FOOL ON THE HILL
Funds That Trade Like Stocks

In 1993, the first Exchange-Traded Fund, the Spider, was launched. This was a landmark product: a fund containing each of the S&P 500 companies but that traded on the American Stock Exchange like any other stock. Since then, Spiders have grown to more than $32 billion in assets, and they have spawned scores of similar ETFs tracking everything from bond indexes to the Singapore Stock Exchange.

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By Bill Mann (TMF Otter)
September 13, 2002

For years, The Motley Fool's investing advice has centered around one single step: "Get thee to an index fund!" Yes, we write about stocks because we enjoy the chase, the chance of beating the average return of the stock market by selecting equities. But really, given that many people lack the time, inclination, or even the experience to choose stocks, I believe that the first advice we ever gave is still the best.

Index funds may give you an "average" return, but that's actually significantly better than average because the majority of actively managed funds fail to match the indexes. We are confident in this regard because some of the best thinkers in the investment community, including Vanguard Group founder John Bogle and Berkshire Hathaway (NYSE: BRK.A) Chairman Warren Buffett, think likewise. Buffett had this to say about indexing back in 1993:

That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.

Ah, but the mutual fund management community caught on to this and rolled out hundreds of their own index funds. There are now several hundred "index" funds, many with expense ratios running as high as 2% per year, as compared with the granddaddy of the index funds, the Vanguard 500 Index (VFINX) at 0.18%. These days, index fund investing is filled with traps. But there is a simple way to avoid paying high fees, and that is to buy them in the form of Exchange-Traded Funds, or ETFs, all of which trade on the American Stock Exchange.

ETFs are funds that trade like stocks. More specifically, they are index funds that trade on the open market. They offer a lethal combination of extremely low cost, versatility, and diversification in a package that costs the exact same amount to buy as a normal stock trade. ETFs track nearly every index you can imagine: the S&P 500, the Dow Jones Industrial Average, the Wilshire 4500, bonds, countries, industries, and sectors. Expenses are minimal, and they are generally transparent because they are deducted from dividends payable to investors. What's not to like?

These products are a dream -- for financial service marketers and for most Foolish investors alike. The first ETF, the Spider (AMEX: SPY), was launched in 1993 and currently has more than $32 billion in assets being tracked. But today, there are nearly 100 different forms. To get a complete list, go to the American Stock Exchange website.

The first time I wrote about ETFs for the Fool was in July 2000. At the time, the vast majority of them were less than a year old.  I remarked then that investing in an ETF might take 10 minutes per year if you stopped to make a sandwich in the middle. This is still essentially true, though the menu of ETFs has broadened.

Sample ETFs

        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 MSCI Japan Index iShares Lehman 20+ Year Bonds TLT Lehman Treasury Bond Index Vanguard Extended Market VIPERs VXF Wilshire 4500 StreetTRACKS Wilshire REIT RWR Wilshire REIT Index

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 of 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: Indexes 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 anytime 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. As a result, they have been used extensively as short-term investments, which is 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." We concur.

Of all of the large scale equities on the three major exchanges, none has the turnover of the Nasdaq 100 Trust (AMEX: QQQ), which sees an average holding time of just 10 days. We recommend you think of ETFs in your Foolish portfolio in the same manner as you would an index fund. Buy them and forget them, except to make additional periodic contributions.

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. Remember, the entire point of an index fund is to practice low-cost, low-maintenance investing.

There are other benefits to ETFs. Particularly among the Barclay's iShares offerings, you have access to the markets of countries around the world. Though the financial system is increasingly globalized, trading of stocks in many companies is still a domestic affair. In order to gain much exposure to Taiwan, for example, an American investor could invest in the few Taiwanese companies that trade in the U.S., but that leaves out some of the most powerful companies in the country.

Alternatively, that investor could set up an account with a brokerage in Taiwan, or with one in the U.S. that has a counterpart in Taiwan. Neither choice is very economical, and trading costs are likely to be extremely high. Or one could simply purchase an ETF specializing in Taiwan, in this case the iShares MSCI --Taiwan (AMEX: EWT), for the cost of a trade at a discount brokerage, plus an annual cost of 0.99%, deducted from dividends. In many ways, these products offer the first low-cost way for U.S.-based investors to gain access to significant portions of the global economy.

Are they perfect for everyone? No. As I described, people who dollar cost average, particularly in small amounts, are likely to see their cost benefits eaten up through higher trading expenses. But for people who are looking to simply index their way to investing, there are dozens of ETF options that can assist.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

When Bill Mann hears really good music, he giggles. Go figure. Bill owns Spiders. Please view his profile for a complete list of his holdings. The Motley Fool is investors writing for investors.