The Age of the Exchange Traded Fund [Fool on the Hill] July 21, 2000

FOOL ON THE HILL: An Investment Opinion
The Age of the Exchange Traded Fund

In the last year, Exchange Traded Funds (ETF) have multiplied as marketers have found a low-cost way for investors to buy indexes. Since the launch of Spiders in 1993, these products have garnered billions of investment dollars. They're inexpensive and tax efficient -- perfect for the long-term investor. And now you can buy an ETF that tracks almost any index you can think of.

By Bill Mann (TMF Otter)
July 21, 2000

Probably by now you've heard of these "funds that trade like stocks." They all seem to have these cute names - Spiders, Diamonds, Cubes, WEBS, Vipers, iShares, and so on.

But these are mutual funds, right? The Motley Fool can't possibly have anything nice to say about them, right?

Dead wrong, in fact. These products are a dream -- for financial service marketers and for Foolish investors alike. Oh, there are some negatives, and we'll discuss those here, but there is much to like about these products, known in aggregate as "exchange traded funds," or ETFs. They have proven so popular that more than 50 new ones have been introduced this year, whereas the first ETF, the Spider, was launched in 1993.

I find these investment vehicles to be quite Foolish. They are low-cost, tax efficient, provide ample diversification among groupings of large businesses, and they are among the least time consuming of all investing strategies. Ten minutes a year? Sure, if you make a sandwich between typing in an order and hitting "send."

A Sampling of Exchange Traded Funds

Name                  Ticker          Index Tracked
Spiders                SPY               S&P 500
Mid-cap Spiders        MDY           S&P Mid-cap Index
Diamonds               DIA         Dow Jones Industrials
Cubes                  QQQ              Nasdaq 100
WEBS Japan             EWJ           MCSI Japan Index
WEBS France            EWQ           MCSI France Index
iShares Russell 2000   IWM             Russell 2000
Technology Sector SPDR XLK     S&P 500 Technology Companies
Financial Sector SPDR  XLF      S&P 500 Financial Companies

(All ETFs trade on the American Stock Exchange)

Best of all, the ETFs available today are index-based. By investing in one of the ETFs, you are simply putting your confidence in the companies in the S&P 500, the Nasdaq 100, S&P 500 Energy Companies, or even the MSCI Index for Hong Kong.

For the investor who wishes to manage some or all of her money passively, but does not want to pay the fees and taxes associated with actively managed mutual funds (to say nothing for their historic underperformance!) ETFs provide significant advantages:

Low Cost Investing: Annual Expenses Range Between 0.1% and 0.65% and are deducted from dividends. The only other fees associated are the trading costs at your brokerage.

Tax Efficient: Indices have much lower turnover than the vast majority of actively traded funds. And by construction remaining investors do not inherit tax liabilities due to others' decisions to sell.

Time Efficient: Many investors do not wish to pore over annual reports and would prefer a more passive approach. Due to their relative diversity, ETFs are ideal for investors who lack the time or inclination to select individual stocks.

Historic Performance: This advantage varies as the number of ETFs and their benchmarks skyrocket. But according to statistics complied by Burton Malkiel, Spiders, the most widely held ETF, have returned on average 3% per year better than actively managed mutual funds since inception.

Flexibility: An ETF may be traded any time the exchanges are open. Open-ended Mutual Funds can only be redeemed at the closing price of the day. Further, ETFs can be shorted, optioned, and margined.

This last item provides the greatest criticism for ETFs. They're almost too easy, and as a result, they have been used extensively as short-term investments, the complete antithesis of index investing. John Bogle, the father of index investing, likened ETFs to a shotgun in a recent speech, saying "they can be used for self defense, or they can be used for suicide."

In investing there is such a concept as having too much of a good thing. In this case, the trading in and out of ETFs eats up any cost benefit by piling on trading costs, something that does not exist in closed-end funds. As a long-term investor, I see the option of trading at any point very much like I see having a fire extinguisher around the house -- the chance that I'll need it is pretty slight, but it's nice to know it is there.

There is another group of investors for whom ETFs would not be appropriate: those who dollar cost average. Since ETFs have no direct investment program, dollar cost averaging would rack up trading costs that would far outweigh any cost benefit over a traditional index fund. For people who are adding small systematic amounts to build up a portfolio, a more efficient route would be to find a no-load, low-expense index mutual fund or to dollar cost average individual companies, just as our own Drip Portfolio has done.

There is one other concern about ETFs. Since they are traded on the open exchange, they do not necessarily have to perfectly track the net asset value (NAV) of their holdings. For example, it is possible that each Spider would trade at a 2% discount to the value of the shares of the companies contained in it. In theory, when such an imbalance occurs, arbitrageurs would step in and buy or sell shares in large blocks (called "creation units") and redeem them for the underlying shares.

This method works quite well in normal trading environments. But as of yet no ETF has been in existence during a major crash, such as the one in 1987. Would arbitrageurs remain active enough in such volatile conditions to maintain balance between the ETFs and their NAVs? Although there is considerable debate on the subject, until such an event occurs in the field, we're really not going to know.

Once the decision has been made to invest in ETFs, you should consider what tendencies that you want your portfolio to take on. Do you want the explosive growth and implied volatility of a Nasdaq 100, or would you prefer holding on to the Dow Jones Industrial Companies? Do you want a low-cost way to invest in Malaysia, or would you like to hold the retail companies in the S&P? At the bottom of this article I'm including links to all of the major ETF offerings available at present.

These fund products are quite appropriate for investors to hold for the long term, in lieu of, or in addition to some individual stocks. They don't drip very well, but for any Index plus a few (IPF) strategy, they provide an elegant and simple alternative to open-ended mutual funds.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion Boards

Links To Exchange Traded Fund Sites:

  • Barclay's iShares
  • Vipers
  • Diamonds
  • Cubes

    Links To Related Articles:

  • The 'Index Plus a Few' Strategy,Fool on the Hill, 4/25/00