Exchangetraded Funds

Exchange-traded funds (ETFs) are offshoots of mutual funds that allow investors to trade index portfolios just as they do shares of stock. The first ETF was the "spider," a nickname for SPDR, or Standard & Poor's Depositary Receipt, which is a unit investment trust holding a portfolio matching the S&P 500 index. Unlike mutual funds, which can be bought or

Table 4.3 ETF Sponsors

CHAPTER 4 Mutual Funds and Other Investment Companies 117

Sponsor

Product Name

Barclays Global Investors

i-Shares

Merrill Lynch

Holders

StateStreet/Merrill Lynch

Select Sector SPDRs

Vanguard

VIPER*

"Vanguard has filed with the SEC for approval to issue exchange-traded versions of its index funds, but VIPERs do not yet trade. Source: Karen Damato, "Exchange Traded Funds Give Investors New Choices, but Data Are Hard to Find," The Wall Street Journal, June 16, 2000.

"Vanguard has filed with the SEC for approval to issue exchange-traded versions of its index funds, but VIPERs do not yet trade. Source: Karen Damato, "Exchange Traded Funds Give Investors New Choices, but Data Are Hard to Find," The Wall Street Journal, June 16, 2000.

sold only at the end of the day when NAV is calculated, investors can trade spiders throughout the day, just like any other share of stock. Spiders gave rise to many similar products such as "diamonds" (based on the Dow Jones Industrial Average, ticker DIA), "qubes" (based on the Nasdaq 100 Index, ticker QQQ), and "WEBS" (World Equity Benchmark Shares, which are shares in portfolios of foreign stock market indexes). By 2000, there were dozens of ETFs on broad market indexes as well as narrow industry portfolios. Some of the sponsors of ETFs and their brand names are given in Table 4.3.

ETFs offer several advantages over conventional mutual funds. First, as we just noted, a mutual fund's net asset value is quoted—and therefore, investors can buy or sell their shares in the fund—only once a day. In contrast, ETFs trade continuously. Moreover, like other shares, but unlike mutual funds, ETFs can be sold short or purchased on margin.

ETFs also offer a potential tax advantage over mutual funds. When large numbers of mutual fund investors redeem their shares, the fund must sell securities to meet the redemptions. This can trigger large capital gains taxes, which are passed through to and must be paid by the remaining shareholders. In contrast, when small investors wish to redeem their position in an ETF, they simply sell their shares to other traders, with no need for the fund to sell any of the underlying portfolio. Again, a redemption does not trigger a stock sale by the fund sponsor.

ETFs are also cheaper than mutual funds. Investors who buy ETFs do so through brokers rather than buying directly from the fund. Therefore, the fund saves the cost of marketing itself directly to small investors. This reduction in expenses translates into lower management fees. For example, Barclays charges annual expenses of just over 9 basis points (i.e., .09%) of net asset value per year on its S&P 500 ETF, whereas Vanguard charges 18 basis points on its S&P 500 index mutual fund.

There are some disadvantages to ETFs, however. Because they trade as securities, there is the possibility that their prices can depart by small amounts from net asset value. This discrepancy cannot be too large without giving rise to arbitrage opportunities for large traders, but even small discrepancies can easily swamp the cost advantage of ETFs over mutual funds. Second, while mutual funds can be bought at no expense from no-load funds, ETFs must be purchased from brokers for a fee.

ETFs have to date been a huge success. Most trade on the Amex and currently account for about two-thirds of Amex trading volume. So far, ETFs have been limited to index portfolios. However, it is widely believed that Amex is in the process of developing ETFs that would be tradeable versions of actively managed mutual funds.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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