ETFs: What The Buzz Is About

In the wake of the mutual fund scandal, more exchange-traded funds are finding their way into individual investors' portfolios

Spiders and VIPERs and Diamonds: Oh my! Catchy names aside, more exchange-traded funds (ETFS) are finding a home in investors' portfolios. Just look at Standard & Poor's Depositary Receipts, a family of ETFs that mirrors the S&P 500-stock index as well as its component sectors, such as energy and financials. Assets in the so-called Spiders grew 90%, to $6.2 billion, in 2003. The entire ETF category, which is dominated by institutional investors, hedge funds, and investment advisers, more than doubled last year, to more than $160 billion.

That's still puny compared with the $7 trillion in mutual funds. But ETFs are gaining favor with individuals, thanks in large part to the fund-industry scandal. And now, Vanguard Group is upping the ante: After introducing two ETFs several years ago, it launched 14 Vanguard Index Participation Equity Receipts (VIPERs) on Jan. 30. Six more ETFs are in the works.

ETFs are cheaper, easier to trade, and, in most cases, more tax-efficient than mutual funds. They can be sold short, and investors can use stop orders and limit orders to get in or out at preset prices -- not possible with mutual funds.

Still, buyers need to choose carefully from among the crowd of roughly 150. Brokerage commissions can make ETF investing expensive. Many funds are volatile and illiquid, and not all are tax-efficient. In some funds, ETF investors have been stuck with a tax bill.

Here are some important issues to consider before you invest in ETFs:

COMMISSIONS AND COSTS. There's no question: ETFs are cheap to own. The typical equity ETF costs just 0.4% annually, compared with 1.4% for the average stock mutual fund, according to Standard & Poor's. But here's the rub: To buy or sell an ETF, you also have to pay a commission, which can range from $5 to $30 online (or more at a full-service broker). Even if you make just four buy-and-sells each year, those costs can add up quickly. They're even more onerous if you're buying only a few hundred shares at a time.

You really get hammered if you try to make systematic investments, also known as dollar-cost averaging. Let's say you want to invest in the popular Spiders. If you pay a $30 commission, those $100- or $250-a-month investments are uneconomical. On the other hand, there is no commission on adding a small amount to a no-load mutual fund. "If you are making a reasonable number of trades, you are always better off with mutual funds," says Christopher Traulsen, an analyst at fund-tracker Morningstar.

ETF expenses are expected to fall further, driven by Vanguard's rock-bottom pricing of its new VIPERs. The annual expense ratio for the new Vanguard Health Care VIPERs (VHT), for example, is 0.28%, while iShares Dow Jones US Healthcare (IYH) charges 0.60%. The top 10 holdings of both portfolios are virtually the same.

There are online sites where you can can check the costs of different ETFs, as well as comparable mutual funds. Morningstar runs one such site that costs $115 a year, but there are free data as well. (

PORTFOLIO CONSTRUCTION. Each ETF owns a basket of securities that represents an index, a subsector of an index, or an industry. ETF investors have more indexes to choose from because providers have sliced market benchmarks into ever smaller pieces.

As a result, a wide range of ETFs is available. More than 85 ETFs track domestic stock indexes, and at least 40 mirror international equity indexes. Aside from Spiders, some of the most popular ETFs include Diamonds Trust Series I (DIA), which track the Dow Jones industrial average, and Qubes (QQQ), which mimic the NASDAQ-100 Index Tracking Stock. More obscure and specialized ETFs include iShares MSCI Belgium Index, which tracks 21 major companies listed in Belgium.

Diversification is in the eye of the beholder. The way indexes are constructed vary widely. With the S&P 500, every stock is represented relative to its market capitalization. So if you think you're getting a broad portfolio, be careful: Nearly 42% of the Qubes's assets are 10 companies, including Microsoft (MSFT ), Intel (INTC ), and Cisco Systems (CSCO ).

Currently, equity ETFs are limited to market indexes and their subsectors. A good place to find portfolio data and other information is on the American Stock Exchange's Web site ( 93% of all ETFs are traded on the AmEx.

Fixed-income investors have limited options. There are only six ETFs that track segments of the U.S. Treasury market. No convertible, muni, junk, international, or Ginnie Mae ETFs exist, but some are expected to be introduced in the next 18 months.

TAXES. Low turnover in the portfolio means index mutual funds realize fewer gains than actively managed funds. ETFs avoid making capital-gains distributions because they aren't required to sell securities to meet redemptions.

That doesn't mean ETF investors are tax-immune. Some ETFs have made capital-gains distributions. As the market soared in 2000, iShares MSCI Sweden Index (EWD ) had to sell some of its Ericsson (ERICY ) holdings at a huge profit -- resulting in a taxable payout -- after its weighting in the index exceeded the maximum 25%.

INTERNATIONAL. ETFs are gaining popularity with investors who want to put money overseas because they thwart some of the pricing issues mutual funds face when the U.S. market closes at 4 p.m. EST. As the fund scandal revealed, market-timers run in or out of foreign funds, betting that overseas markets will rise or fall the next day based on events that happened while those markets were closed. That can hurt a fund's long-term investors. ETFs have a built-in mechanism to hinder market-timers. An ETF trades all day long, so news gets factored into the price.

Even so, many single-country indexes are quite concentrated, and some are thinly traded. On any given day, there might not be much interest in, say, South Africa. As a result, if you decide you want to purchase or sell iShares MSCI South Africa Index Fund (EZA ) on such a day, you might not get the best execution. During a recent trading session, there was a 9 cents difference in what buyers were willing to pay for the shares and what sellers wanted for them. "It certainly isn't the 1 cents [difference] you see on stocks," says Joe Ezernack, a trader at PMFM Funds, which offers a mutual fund that invests in ETFs.

LIQUIDITY. Indeed, problems can arise when investors try to trade less popular ETFs. For a long-term investor, that 9 cents may not matter much. But for active traders, it makes a difference. That's why it's important to check an ETF's daily trading volume. "The first fund of its kind to come out typically attracts the dollars and keeps the trading volume," says Donald Cassidy, a senior research analyst at Lipper Inc. The MidCap Spiders (MDY), introduced in 1995, have roughly 12 times the volume of iShares S&P MidCap 400 (IJH ). If history is any guide, then, the most seasoned ETFs are still the best.

By Lauren Young

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