FOOLISH FOUR PORTFOLIO
The Latest Indexing Craze: ETFs

By Barbara Eisner Bayer (TMF Venus)
June 27, 2000

The latest hot acronym to hit Wall Street is ETF. No, it doesn't stand for the following honest-to-goodness acronyms: Electrical Time Fuze, Elektrotehnicki Fakultet u Beogradu, or Encrypted Transmission Failure. The newest acronym stands for "Exchange Traded Fund."

ETFs (also called index shares) track a specific basket of securities and trade continuously on the major exchanges like an ordinary stock. The pioneering big daddy of ETFs was the Standard & Poor's Depositary Receipts (AMEX: SPY) -- also known as SPDRs, pronounced "Spiders" -- which appeared in 1993. These were followed by the Dow Diamonds (AMEX: DIA), a basket of the 30 Dow stocks, and the Nasdaq 100 Shares (AMEX: QQQ) -- a.k.a. Qubes -- which track the Nasdaq 100 stock index. Even though they've only been around since March 1999, Qubes are so popular, their daily trading volume rivals the companies on the New York Stock Exchange. (Today, only three companies on the Big Board traded more briskly.)

Jumping into the market at full throttle is Barclay's Global Investors (BGI), introducing a new index vehicle called iShares, which are taking the investment community by storm. The iShares will mirror common indexes such as the S&P 500, the Russell 1000, 2000 and 3000, and the various Dow Jones indices, giving the current EFTs a run for their money. Barclay's is planning to launch more than 50 new EFTs in the coming months.

Not to be outdone, Vanguard announced in May that it would roll out its own ETFs in the third quarter of this year and call them Vipers (Vanguard Index Participation Equity Receipts). Vanguard intends to allow investors who currently own their index funds to move to the ETFs at no charge.

Are ETFs good for investors? You betcha.

"This is the natural evolution of investing, the marriage of stocks and funds," says Lee Kranefuss, chief executive of Individual Investors Business at BGI. "It puts together the best benefits of both."

The most obvious advantage, of course, is that iShares, Vipers, and their lot can be bought and sold on the major exchanges all day long, unlike mutual funds, which are priced daily at 4 p.m.

There may be tax advantages as well -- ETFs can't be forced to sell profitable stock positions if too many shareholders cash out at once like index funds can. That has always been one of the disadvantages of index funds. No one likes an unexpected capital gain. Besides having to pay the taxes on it, there's the hassle of reporting it.

Some unplanned capital gains might crop up if a company is taken over or dropped from the index, though. The tax advantages are relative and depend on what happens with the stocks that are in the index that is being followed.

Another advantage is that ETFs can be shorted and bought on margin. Fools don't necessarily perceive this as a positive thing -- we don't think that borrowing money to buy stocks is a smart way to invest, although in limited amounts by experienced investors it can be useful. And while we support shorting as an advanced investing technique in accordance with Step 12 of our 13 Steps to Investing Foolishly, shorting an index requires you to predict the direction of the market, which is extremely difficult to do accurately enough to come out ahead in the long run, and much more difficult than shorting individual stocks. Shorting a stock can be an educated investment; shorting an index is a gamble.

Perhaps the greatest benefit of ETFs is that investors will now have instant exposure to a diversified portfolio of stocks. Alas, this benefit can also become a liability, as investors have a wider field of indices from which to choose. Therefore, investors will need a more extensive understanding of what each index tracks, and how each will fit into their overall portfolios. In the past, ETFs were as close to no-brainers as investors could get; now a little brain food will be necessary in order to select the ETFs most appropriate to individual investing goals.

Another strong benefit -- low cost -- could potentially be the greatest danger to individual investors if it encourages fast trading rather than long-term holding. Between the low annual operating expenses that ETFs charge, and the advent of deep discount brokers, it's never been easier or cheaper to buy and sell an index. According to the Bogle Financial Markets Research Center, the average holding period for SPDRs was 19 days during the first five months of 2000, while the average holding period for QQQs was just four days. Somebody's been day trading! Foolishly naughty. And dangerous.

Last but not least, investors interested in dollar cost averaging should stick to a traditional index fund. If you invest via small monthly installments, it would make no financial sense to get involved in the brokerage commissions that buying ETFs would generate on a monthly basis when an index fund will let you add to your balance for free.

For many investors with a long-term vision who can embrace the benefits of ETFs without falling into the trading traps that accompany it, investing through ETFs can be quite rewarding to the pocketbook, and a superior alternative to mutual funds.

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Top Dow Stocks
( RP Order )

6/27/00

1. Philip Morris
   (NYSE:MO)
2. * Caterpillar
   (NYSE:CAT)
3. * Int'l Paper
   (NYSE:IP)
4. * AT&T
   (NYSE:T)
5. * DuPont
   (NYSE:DD)
6. General Motors
   (NYSE:GM)
7. Honeywell
   (NYSE:HON)
8. Eastman Kodak
   (NYSE:EK)
9. SBC Comm.
   (NYSE:SBC)
10. JP Morgan
   (NYSE:JPM)

NOTE: Today's Foolish Four stock selections are marked with an asterisk.

Foolish Four Portfolio

6/27/2000 Closing Numbers
Ticker Company Day Chg % Chg Price
CATCATERPILLAR INC7/82.51%$35.69
EKEASTMAN KODAK-3/16-0.31%$60.19
GMGENL MOTORS1/40.41%$60.69
JPMMORGAN (JP)5/160.26%$118.75

  Day Week Month Year
To Date
Since
12/24/1998
Annualized
Foolish Four .57% 1.02% -6.78% -12.61% 7.53% 4.92%
S&P 500(DA) -.32% .63% 2.11% -1.27% 18.65% 11.98%
NASDAQ -1.36% .35% 13.47% -5.17% 77.62% 46.25%
DJIA (DA) -.37% .96% -.17% -8.63% 15.97% 10.30%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
12/24/19989JPM105.514$118.7512.54%
12/27/199920EK65.088$60.19-7.53%
12/27/199918GM73.257$60.69-17.16%
12/24/199824CAT43.083$35.69-17.17%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
12/24/19989JPM$949.63$1,068.75$119.13
12/27/199920EK$1,301.75$1,203.75($98.00)
12/24/199824CAT$1,034.00$856.50($177.50)
12/27/199918GM$1,318.63$1,092.38($226.25)
  Cash: $79.92  
  Total: $4,301.30  

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.
• DJIA (DA) = dividend adjusted. Dividends have been added to the total return of the DJIA.

Note
The Foolish Four Portfolio was launched on December 24, 1998, with $4,000. Additional cash is never added, all transactions are discussed and explained publicly before being made, and returns are compared daily to the S&P 500 and the Dow. (Dividends are included in the yearly, historic and annualized returns.) Stocks are chosen once per year using a formula based on dividend yield and price. See The Foolish Four Explained for details.