The Hottest Funds In Town

The fast growth of exchange-traded funds has the mutual-fund biz scrambling

When five stock market veterans started their own financial-advisory firm in August, 2002, they made a bold decision: They would avoid investing in mutual funds for their clients and instead use only exchange-traded funds, or ETFs. It was an easy call, even though one of the partners in the new firm, San Francisco-based Main Management LLC, had once founded a mutual-fund company. Another partner, J. Richard Fredericks, who was a stock analyst for more than two decades, says the aim was "to avoid the common mistakes we had made throughout our careers, to avoid the enemies of our returns -- high fees, expenses, turnover, and taxes." So far it has worked. After taxes and fees, the firm has returned 54%, through Mar. 31.

Sick of the high expenses charged by mutual funds and burned by the industry's scandals, investors have been pouring billions into low-cost ETFs. The front line in this battle is drawn around the mountain of cash that investors have in index mutual funds. ETFs -- fixed baskets of stocks, bonds, or other securities that track a benchmark -- are an obvious alternative. And they are winning this fight handily, capturing 6 out of every 10 dollars flowing into indexed portfolios last year. Already, ETFs have scooped up about 30% of the $730 billion invested in such funds.

Now they are poised to grab an even larger share as they find ways around hurdles that have deterred some investors. Because investing in an ETF is like buying stock, commissions are charged on each trade. By contrast, many mutual funds carry no up-front charge. This means that ETFs have been an expensive way to invest for those who regularly add small amounts to their accounts according to a set schedule -- a practice called dollar-cost averaging -- or who regularly rebalance their holdings depending on what the market is doing. ETFs haven't really cracked the vast 401(k) market, either. But firms are quickly developing strategies that cut these costs by, for example, bundling trades.

The threat posed by ETFs to the mutual-fund industry doesn't end there. They are angling for the roughly 88% of mutual funds' $6 trillion in assets that are held in actively managed funds. This year ETFs could win regulatory approval to begin rolling out actively managed versions. But they'll have to go through a technical contortion to pull this off, and skeptics says they face uncertain odds.

Meanwhile, the ETF boom is creating new investment powerhouses. So far the king of ETFs isn't Merrill Lynch (MER ) or Fidelity Investments but San Francisco's Barclays Global Investors. Last year, Barclays' line of ETFs, iShares, took in roughly $44 billion. Only two mutual-fund companies, Vanguard Group Inc. and American Funds Group, reeled in more. Keeping up its defenses, Vanguard is making its index funds cheaper for many investors and expanding its own ETF offerings. "Mutual-fund companies don't want the ETF industry to succeed," says Joseph H. Moglia, chief executive of online brokerage Ameritrade Holding Corp. (AMTD ).

ETFs have several advantages for ordinary investors. The typical ETF is cheaper to own and easier to buy and sell than the typical mutual fund. It's also potentially more tax-efficient because it rarely distributes capital gains, as many mutual funds do each year. Unlike a mutual fund, ETF shares -- which trade all day on an exchange -- are sold to third parties rather than back to the management company. This avoids the problem of mutual-fund managers being forced to sell holdings to meet redemptions. Even if institutions or hedge funds trade quickly in and out of ETFs, smaller, long-term investors aren't hurt by all this selling.


At the same time, the tough market environment since 2000 has favored indexed funds. Investors in actively managed funds typically give up 40% to 60% of their gross returns to taxes and fees, according to fund researcher Lipper Inc. That may be tolerable when market gains top 20% but not when returns are in the low single digits as now. So lots of investors are shifting money from individual stocks and actively managed funds into index funds. In 2002 index mutual funds and ETFs accounted for 10% of the assets of all funds. Today it's 12%, according to Boston-based Financial Research Corp. ETFs are getting the lion's share of this money because they offer a wider variety of choices -- everything from funds that buy dividend-rich stocks to those pegged to gold bullion. There are about 90 different benchmarks tracked by ETFs, while index funds follow only about 50.

ETFs began 12 years ago when the American Stock Exchange launched SPDRs, which track the Standard & Poor's 500-stock index. (Like BusinessWeek, S&P is a unit of The McGraw-Hill Companies (MHP ).) For the next decade, ETFs were used largely by institutions with billions to invest or very wealthy individuals. Hedge funds used them to short the market or to park extra cash. After the mutual-fund scandals erupted in 2003, retail investors started piling in. Barclays estimates that retail investors now account for half its assets, up from 30% two years ago. Total assets in ETFs jumped by more than 50% last year, to $227 billion.

And the money promises to keep pouring in. Increasingly, the trend is being driven by financial advisers such as Harold R. Evensky in Coral Gables, Fla. He has been switching from actively managed portfolios such as the large-cap value Dodge & Cox Stock Fund (DODEX ) to ETFs as the core of his wealthy clients' equity holdings. Some $90 million of the $433 million Evensky oversees is now in ETFs. "With ETFs we can replicate the returns of some of the finest active managers in existence, but very tax-efficiently," he says. "Even when market returns are high, we're likely to remain significantly invested with ETFs."

ETFs are also winning over brokers, who long regarded mutual funds and individual stocks as the only places to put customers' money. Now brokers are starting to create accounts that use only ETFs. Investors are charged an annual fee, typically 1% to 2% of assets, rather than a commission on each transaction. A.G. Edwards Inc. (AGE ) and Smith Barney (C ) have offered such accounts for a few years. In recent months, other firms, including Raymond James Financial Inc. (RJF ) and Ryan Beck & Co., have rolled out similar programs. Morgan Stanley (MWD ), which just added ETFs to one of its offerings, plans to expand its lineup later this year.

To sign up people who handle their own investing and trade regularly, the industry is working to cut the cost of commissions. Last fall, Ameritrade introduced an advisory service that uses ETFs for its clients' portfolios. Investors can rebalance their portfolios or add money to an account without paying a commission each time they trade. Instead, Ameritrade charges an annual fee -- 0.50% for accounts up to $100,000 and 0.35% for larger ones. ShareBuilder Corp. in Bellevue, Wash., aggregates its trades weekly so investors don't get hit with big charges. Customers pay, at most, $4 a trade, which makes sense for investors who put at least $500 a month into ETFs. And it's likely to be only a matter of time before investors are able to buy an ETF straight from the company sponsoring it. NASDAQ says it's considering a direct-investment program for the NASDAQ-100 Index Tracking Stock, or Qubes, allowing investors to bypass brokerage firms and their commissions.

The industry is also making ETFs easier to use in 401(k) plans, potentially unlocking a $2 trillion pot of cash. Firms such as Invest n Retire LLC in Portland, Ore., and Banneker Capital Management in Owings Mills, Md., bundle trades from different accounts and then execute them once a day. That keeps expenses down. The transaction costs for the $5 million 401(k) plan at technology firm Navmar Applied Sciences Corp., which uses mainly ETFs, totaled just $73 in March, says Chief Financial Officer Robert Bauder.

While skeptics concede that ETFs may be able to penetrate smaller plans with assets of under $100 million or so, they argue that it will be tough to break into bigger ones, particularly those with $1 billion or more in assets. These plans enjoy huge economies of scale, with dirt cheap annual expenses. "Larger plans can negotiate excellent pricing, so ETFs aren't necessarily going to be attractive," says Lori Lucas, director of participant research for Hewitt Associates Inc. (HEW ) Darwin Abrahamson, CEO of Invest n Retire, begs to differ. His firm is bidding to run two plans, each with more than $1 billion. In one, he says, the average investor is currently paying 0.30% a year. A similar portfolio using mainly ETFs, he figures, would cost 0.10% to 0.15%.

Vanguard, the mutual-fund firm with the most at stake, is fighting fire with fire. In 2001 it rolled out its first ETF, Vanguard Total Stock Market VIPERs, which follows the MSCI U.S. Broad Market Index. In March it introduced three international VIPERs, giving it 23 ETFs in all. Vanguard is also considering ETFs that track the bond market, and it's stepping up marketing aimed at financial planners.

Mutual-fund companies are slashing the charges on their index funds as well, in part to keep up with ETFs. Fidelity -- which launched an ETF that tracks the NASDAQ Composite Index in 2003 -- lowered the expense ratio on its index funds from a high of 0.47% to 0.10% in August. A week later, E*Trade Financial Corp. (ET ) cut expenses on its S&P 500 fund to 0.09%. Then, in April, Vanguard made it easier to qualify for its cheapest share class -- the Admiral shares of its S&P 500 fund, which charge just 0.09%. Slashed, too, are the prices of Vanguard's own ETFs: All now have lower expense ratios than similar ETFs offered by competitors. Two of its VIPERs have an expense ratio of just 0.07%, making them the cheapest mass-market investment options available.

The battleground will soon shift to actively managed money. Tony Baker, managing director of the ETF Marketplace at the AMEX, says the first application for an actively managed ETF could be filed with the Securities & Exchange Commission in the next few months. The problem is that exchanges must publish an estimated value of an ETF throughout the day, just as they do with stocks. This is easily done because there's no mystery to what makes up the index that an ETF is tracking. But for competitive reasons, managers of actively run funds are reluctant to reveal what they own -- even on a quarterly basis, as they are required to do. To get around this, Baker proposes that ETFs create tracking portfolios to mimic the intra-day price movements of the underlying fund. Firsthand Capital Management recently filed for a product that gets one step closer: The fund would reveal its holding daily.

Not everyone is convinced that actively managed ETFs will catch on. For one, there's a chance they'll be mispriced because the price would be based on the proxy portfolio rather than the ETF's actual holdings. Also, much of their cost advantage may be lost. "I think a lot of people are counting on actively managed ETFs for their expansion and growth," says Morningstar Inc. (MORN ) analyst Dan Culloton. "But I'm dubious about their value to individual investors."

When it comes to managed investments, big mutual-fund companies will continue to have the upper hand because of their plentiful marketing dollars and powerful distribution channels. "We want to provide low-cost funds, so our challenge is not to spend as much on [marketing]," says Lee T. Kranefuss, CEO of the iShares division at Barclays, which manages more than $115 billion in ETF assets. Barclays estimates that it spends about one-fifth as much as major mutual-fund companies do on marketing.

This battle is just beginning. But by creating better, cheaper, and more efficient options, it's already making investors into big winners.

By Adrienne Carter in Chicago, with Justin Hibbard in San Francisco

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