Exchange Traded Funds

• Exchange-Traded Indexed Securities

• Are the Risks of Exchange-Traded Funds being Downplayed?

Exchange-Traded Indexed Securities
By Michael O'Neil Meditz, Associate Editor
(http://www.indexfunds.com)

Exchange-traded funds (ETFs) are increasing in popularity, as they are often responsible for approximately 50% of the daily trade volume on the American Stock Exchange (AMEX). ETFs are passive funds that track their related index and have the flexibility of trading like a security. They are managed by professionals and provide the investor with diversification, cost and tax efficiency, liquidity, marginability, are useful for hedging, have the ability to go long and short, and some even provide quarterly dividends.

ETFs are unit investment trusts (UITs) that have two markets. The primary market is where institutions swap "creation units" in block-multiples of 50,000 shares for in-kind securities and cash in the form of dividends. The secondary market is where individual investors can trade as little as a single share during trading hours on the exchange. This is different from open-end mutual funds that are traded after hours once the net asset value (NAV) is calculated.

The most widely traded and well-known ETF is the SPDR (pronounced spider, Standard and Poor's Depository Receipt). Other ETFs include Diamonds (Dow Jones Industrial Average), Qubes (Nasdaq-100 Index Tracking Stock) named after the ticker, QQQ, and Webs (World Equity Benchmark Shares). Webs mirror indices in foreign equity markets. There are currently 30 ETFs available on the AMEX and they include 17 Webs, 11 SPDRs (includes sectors), and one Qube and one Diamond.

Tax Advantages

Like open-end index funds, ETFs do not engage in active management and experience very low portfolio turnover. Also, ETFs provide additional tax benefits that mutual funds cannot offer. Mutual funds sell securities to cover redemptions that produce capital gains. ETFs transfer out, not sell, securities "in-kind" in the primary market. The institution can determine which, and how much of a security they are going to swap as long as it is of equal value to the amount being redeemed. The benefit of swapping securities at the lowest cost-basis is that it avoids capital gains. However, individual investors trading in the secondary market could be subject to capital gains since they do not have the opportunity to swap securities in kind.

Costs

Most open-end index funds can be purchased directly from their distributors without a transaction fee. Those bought through the discount brokers like Charles Schwab or E*Trade usually include a transaction charge of $15-$30 or more. Exchange-traded funds, on the other hand, are subject to regular brokerage commissions on all purchases and sales. An additional cost to investors in ETFs is the "spread" between the bid and ask price. This can amount to over 1% of the purchase or sale price.

Expense ratios (ER) are very similar among ETFs and open-end index funds. However, there is often an additional cost of ownership to holding ETFs. SPDRs, for example, pay dividends quarterly directly to investors. An open-end index fund like the Vanguard 500 Index reinvests dividends into new shares as they are paid. The delay of dividend reinvestment with ETFs is often referred to as "dividend drag."

* 0.18% after expense reimbursement by fund manager.

New and Improved ETF

Barclays Global Investors (BGI) currently manages all 17 of the WEBs available on the AMEX and has filed with the SEC with plans to offer 51 new ETFs including 45 domestic and 6 international sector and wide-market indices. BGI is planning a competitive pricing strategy and the internal expense ratio estimates range between 8 and 12 basis points. Their goal is to design tax efficient and less expensive funds to grab market share. A key difference between the Barclays securities and the currently available ETFs is that they will be registered with the SEC as open-end funds. BGI is still keeping the benefits of exchange-traded securities while overcoming the problem of dividend drag.

Exchanged-trade index funds offer investors even greater flexibility than open-end index funds and may offer cost and tax advantages. Investors should be aware, however, that the unique advantages of ETFs, such as greater trading flexibility and the ability to sell short, might turn out to be very costly features in the long run. Investors are still wise to avoid the temptation of market timing and use ETFs as part of a diversified, long-term investment strategy.

©1999 IndexFunds.com

A key risk inherent in exchange-traded funds (ETFs) is being misrepresented by its proponents, charges Mercer Bullard and the Consumer Federation of America. Sponsors of ETFs responded variously-challenging the critics' data, agreeing, or vowing to change future practices.

At issue is clarifying the nature of ETFs to investors. While most ordinary mutual funds can only be bought or sold at the end of the day at the calculated net asset value (NAV), ETFs are traded through the day on the American Stock Exchange at prices that aren't guaranteed to match the underlying value of the stocks in the portfolio.

With many ETFs the variations are negligible. But some of the funds trade at prices that can vary considerably from the correspondent NAV at the time of the trade. In such cases an investor who inadvertently buys an ETF at a premium to its underlying value is exposed to natural corrective forces (namely savvy traders who exploit the difference between the trading price and the NAV).

According to Mr. Bullard, the risk of price variation is greatest on international stocks. Materials from ETF proponents and the American Stock Exchange have "misrepresented" the risk, he contends.

In a Wall Street Journal article by Karen Damato and Aaron Lucchetti, various ETF supporters responded to the charges. Lee Kranefuss of Barclays Global Investors, said his firm had fully disclosed the mechanics and risks of ETFs. Even so, in May Barclays agreed to provide additional information on its ETF Web site about the daily premiums and discounts of some of its iShares.

 Presently many of the ETFs that trade on the American Stock Exchange have three ticker symbols: one shows the trading value, another shows the estimated NAV of the underlying stocks, and the third shows the official NAV of the underlying stocks at the previous day's close.

Unfortunately, this information is presently only available for United States-based ETFs. The same information is not readily available to most retail investors trading in low-volume international funds. With the recent exposure to this information, however, look for this information to soon appear.

Gus Fleites, director of ETFs at State Street Global Advisors, agreed that price variation can be significant for some funds and may not always be explained clearly. Regarding ETFs that track international-stock indexes or lightly traded U.S. industry sectors, he noted, "Retail investors, beware…."

Fund specialists, including Mr. Bullard, have praised ETFs not just for allowing intra-day trading, but also for their ability to feature lower operating expenses and greater tax efficiency. Expect the transparency of trading/NAV differentials to increasingly fall into the public domain. Traders, not funds, gain from the premiums/ discounts.

With Barclays already voluntarily posting the information, it seems likely the problem will soon to be largely resolved. Aside from increased transparency cutting down the gap, one expects that the increased attention to the issue will also help narrow the premiums that are exploited by traders. In the meantime, let the buyer beware.

07/07/00