Stock-Mutual Fund Hybrid Attracting Traders, Investors
They’re the hottest things in the stock market--even though they’re not stocks and many of them don’t even exist yet.
They’re exchange-traded mutual funds, a hybrid between stocks and traditional mutual funds. And they’re catching on fast with individual investors.
ETFs take the idea of a staid “index” mutual fund and make it a vehicle for trigger-happy online investors.
Like a traditional index fund, ETFs track the performance of passive indexes, such as the Standard & Poor’s 500 or the Dow Jones Internet-stock index.
But ETFs have a big kicker. While traditional funds are of minimal use to traders because they can be bought and sold only at the end of each trading day, ETFs are priced continuously and trade all day long.
That helps traders in a big way: Until now, anyone seeking to bet on a short-term rise in a market sector has been generally limited to purchasing shares of individual companies. You could profit handsomely if your stocks jumped. But you could get creamed if the stocks you picked to represent the sector crumbled.
The risk obviously is cut by owning a broad swath of stocks, which is what ETFs provide.
ETFs have other advantages for frenetic traders. They can be bought on margin (i.e., on credit) and can be borrowed and “sold short,” a bet that the underlying basket of stocks will decline in value. The latter use can provide a way to hedge against a broad market decline or a decline in a particular stock sector.
Anecdotal evidence suggests that ETFs--especially the enormously popular QQQ, or Cube, security that tracks the Nasdaq 100 index of major technology stocks--already are favorites of individual investors.
Data indicate that amateur investors make up about 80% of the QQQ’s shareholder base, and that the average investor holds on for only four days before selling, experts say.
Though they’ve been embraced by active traders, ETFs are being pushed by the companies behind them as buy-and-hold investments--and, indeed, ETFs have some advantages for long-term investors that are worth a look.
In part because ETF sponsors now are locked in a price war with one another, these securities carry lower annual expense ratios than regular index funds. The savings can add up over time.
ETFs also can be more tax-efficient in shielding investors from unwanted capital gains payouts, advocates say.
“The primary benefits are the tax [efficiency] and the [low] costs, and those are going to benefit those who buy and hold for the long term,” said Lee Kranefuss, head of the individual investor group at Barclays Global Investors in San Francisco, which is rolling out a series of ETFs known as iShares.
But before you jump headfirst into ETFs, realize that they have some shortcomings for long-term investors--and that some of their supposed advantages are open to debate.
The biggest deficiency of ETFs is that, like stocks, investors must pay brokerage commissions each time they purchase or sell shares. That means they’re probably impractical for investors who use a dollar-cost averaging strategy of automatically purchasing a modest sum each month.
“For investors with a short-term time horizon, ETFs provide flexibility and have some advantages,” said Gus Sauter, head of equity indexing at the Vanguard mutual-fund group, the index-fund giant, which plans to launch its own ETFs soon.
“On the other hand, for investors with long-term time horizons, there are frequently advantages offered by traditional index mutual funds,” Sauter said.
The term ETF now is used as an umbrella for all sorts of similar products, including unit investment trusts and sector securities called HOLDRs. Most ETFs trade on the American Stock Exchange.
The first ETF, Standard & Poor’s Depositary Receipts, known as Spiders, came out seven years ago, tracking the S&P; 500 index.
Today, there are about four dozen ETFs holding $40 billion in assets. But the numbers are mushrooming. Several dozen others are scheduled to launch this summer.
ETFs now track a bevy of indexes, allowing investors to make bets on ever-thinner slivers of the U.S. stock market. For example, Barclays recently unleashed ETFs tracking telecom and financial stocks, and will roll out offerings on such specialized indexes as the Russell 2,000 small-stock growth index this summer.
Barclays is an index-fund behemoth that previously catered to institutional investors. State Street Global Advisors, a Boston-based institutional investment firm, is another notable player rolling out ETF products.
Merrill Lynch & Co. is behind HOLDRs, which, though not technically ETFs, are similar in makeup.
One big difference between an ETF and a HOLDR is that ETF shareholders own units of a security that tracks a particular index. HOLDRs, by contrast, are “baskets” of 20 stocks in an industry subgroup, such as Internet infrastructure companies, that are chosen by Merrill rather than being part of a specific index.
Also, HOLDRs give investors beneficial ownership of the underlying stocks. That means that investors can turn in a HOLDR and receive shares of the actual stocks in the index. That gives them a degree of control over taxes by deciding which stocks to sell and when.
In some ways, ETFs, HOLDRs and other such instruments are similar to closed-end mutual funds, which also trade on exchanges. But closed-end funds have a fixed number of shares, and their share prices can trade at big discounts or premiums to the true value of the underlying stocks.
Often, closed-ends trade at discounts. That makes them a bad bet for investors and is one of the main reasons closed-ends are a backwater in the fund world.
ETFs, by contrast, have exchange-floor specialists and other sponsoring institutions that control the number of shares in existence and, at least theoretically, prevent the fund shares from trading at significant discounts or premiums.
Will it always work that way in practice? Big Wall Street firms are supposed to intervene to prevent discounts or premiums on ETFs because there are “arbitrage” profits to be made by doing so.
But to do this, there must be a critical mass of trading volume, known as liquidity. In other words, the firms must be able to easily trade in and out of the stocks.
But some experts worry that liquidity is too low in some lesser-known indexes, thus running the risk that Wall Street firms can’t, or won’t, act to narrow the pricing discrepancies of some ETFs.
For example, a Wall Street firm might have trouble in quickly assembling all the stocks in the Russell 2,000 index, said Gus Fleites, director of exchange-traded funds at State Street. Therefore, Wall Street might allow a discount or premium on an ETF to grow very wide before stepping in to smooth out the disparity, he said.
Thus, investors should be careful in buying lesser-known indexes in which trading volume is light, he said.
“Not every index is created for an ETF,” he said. “The liquidity of the underlying securities is really critical for the success of an ETF.”
Besides intraday pricing and other features favored by short-term traders, here are some potential ETF advantages for long-term investors:
* Lower Fees: ETF annual management fees (which come directly out of the portfolios) are less than those of competing index funds. Vanguard’s benchmark S&P; 500 fund, for example, levies a yearly fee of 0.18% of assets, while the Barclays’ iShares S&P; 500 fund charges 0.09%.
Because they don’t deal directly with shareholders, ETF companies avoid expenses such as maintaining customer accounts and mailing regular account statements.
* Hedging Tool: Some individuals have used ETFs as a way to hedge against drops in the value of technology-stock holdings. For example, an investor with a concentration of large tech stocks might sell short the QQQ index.
In a short sale, an investor bets that a stock or index will fall in price. Therefore, losses on individual stocks could be partially offset by gains in a QQQ short sale.
* Tax Efficiency: Traditional index funds incur capital gains in two ways, each of which is passed on to shareholders.
First, the indexes are “rebalanced,” meaning that stocks are periodically added to, and deleted from, the fund. Second, in market downturns investors sometimes redeem their holdings, forcing the funds to sell stocks. Both ways can create taxable capital gains for remaining shareholders.
ETFs are equally affected by rebalancing. But ETFs aren’t affected by redemptions. As with stocks, sellers unload their shares on the open market. That is likely to depress an ETF’s share price, but doesn’t force the fund itself to sell stock. Therefore, remaining shareholders avoid an unwanted tax bill.
However, ETF critics maintain that the tax issue is overblown. Vanguard’s Sauter argues that his S&P; 500 fund can control tax issues, in part by selling the most expensive shares when redemptions occur. In fact, the fund can often create taxable losses that investors can use to reduce their taxes, he said.
Even if a whopping 15% of assets in his S&P; fund were redeemed today, Sauter said, the fund could avoid incurring capital gains. If the S&P; dropped 20%, it could handle 44% of assets being redeemed without realizing capital gains, he said.
Finally, a word about dividends and ETFs: When the market is rising, unit trusts such as S&P; Spiders could be at a slight disadvantage to index funds with regard to dividends. Whereas funds can immediately reinvest the cash dividends paid out by companies in new stock, unit trusts must hold those proceeds in cash until distributing them to investors at quarter-end. That creates a so-called cash-drag.
The issue has been minimal in recent years because stock dividend yields have been so paltry, but could be an issue if yields rise.
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Times staff writer Walter Hamilton can be reached at walter.hamilton@latimes.com
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A Sampling of ETFs
The universe of exchange-traded funds--a broad term for easily tradable securities that track market indexes or industry sectors--is growing rapidly. Here’s a look at ETFs already trading, and some that are expected to be launched soon by major financial sponsors. Nearly all trade on the American Stock Exchange.
Major Market Indexes
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ETF Mon. Index/sector tracked ticker symbol price Standard & Poor’s 500 SPY $147.13 IVV 146.97 S&P; mid-cap 400 MDY 91.25 IJH 99.48 S&P; small-cap 600 IJR 105.08 Nasdaq 100 QQQ 93.86 Dow Jones 30 industrials DIA 108.25 Russell 2,000 small-cap IWM 102.00
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Sector Indexes
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Index/sector tracked ticker symbol price S&P; 500/Barra value index IVE 62.00 S&P; 500/Barra growth index IVW 87.75 Dow Jones telecom IYZ 61.50 Internet HOLDR HHH 123.50 Biotech HOLDR BBH 153.06 Telecom HOLDR TTH 74.88 Dow Jones Internet IYV 73.63
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Sector Indexes to be Launched Soon
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Index/sector tracked ticker symbol price Dow Jones utilities IDU NA Dow Jones real estate IYR NA Dow Jones energy IYE NA Dow Jones financial services IYG NA
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Source: Times research
