Exchange-Traded Funds Come of Age
Assets in exchange-traded funds--those index-tracking shares promoted as low-cost, easily tradable and tax-efficient alternatives to traditional mutual funds--have grown much more slowly so far this year after roughly doubling every year since 1995.
ETFs, first offered in 1993, have gained acceptance among retail and institutional investors alike. But now that most benchmark stock indexes are covered by ETF securities, some analysts wonder: Has the industry matured, and where does it go from here?
The major financial firms that created index ETFs see potential in new twists on the basic idea, including fixed-income ETFs, shares aimed at overseas investors, and even ETFs based on actively managed stock portfolios.
Proponents say the ETF industry still has tremendous growth ahead. They note that, though ETF assets have zoomed to more than $72 billion from less than $16 billion at the end of 1998, traditional mutual funds still have almost 100 times their assets.
But some say that’s for good reason.
“ETFs are a strong competitor for mutual funds, but at this point not a threat,” said Morningstar Inc. analyst Christopher Traulsen in Chicago. “They are an incredibly useful tool, but investors should be aware of their significant disadvantages.”
Brokerage costs in buying and selling ETFs, for example, can more than wipe out the benefit of their lower management expense ratios when compared with regular index mutual funds.
Meanwhile, though actively managed ETFs could in theory give mutual funds a run for their money, the idea is no cinch to clear regulatory hurdles or attract much investor interest even if it does, analysts say.
The popularity of ETFs to date stems from what is at once their complex, yet simple, structure. ETFs track the performance of broad indexes such as the Standard & Poor’s 500, the Nasdaq 100 and the Dow Jones industrial average, and also narrower market sectors such as technology, health care and real estate.
Owning an ETF, then, essentially is owning all of the stocks underlying the index on which the ETF is based.
But unlike traditional index mutual funds, ETF shares can be bought and sold throughout the day (rather than just at the close of trading). They also can be bought on credit, and sold “short” (a bet on falling prices).
Investors trade ETFs with each other, primarily via the American Stock Exchange. What is supposed to keep an individual ETF price in line with its underlying index is the process of “arbitrage”: Institutional investors and brokerages can make money trading ETFs against their underlying share baskets if even small pricing disparities arise between the two.
So far, most ETFs have worked as planned. Traders like them for their flexibility and the speed with which they can be bought or sold, like any individual stock.
For long-term investors the appeal is that ETFs generally charge lower annual management expenses than comparable mutual funds, and they can be more tax efficient--meaning they pay out few, if any, annual capital gains distributions.
“Without exception, the ETF is the most effective asset-allocation tool that has been created,” said Kristoph J. Rollenhagen, an analyst at Prudential Securities in New York. He noted that popular ETFs such as the “Qubes,” which trade under the symbol “QQQ” and track the Nasdaq 100, and “Spiders,” which trade as “SPY” and track the S&P; 500, have fans ranging from small investors to big hedge funds.
The Qubes are by far the most actively traded ETF and the overall volume leader on the Amex.
Considering Transaction Costs
But investors should carefully consider transaction costs when weighing ETFs against regular funds.
Barclays Global Investors’ “iShares” S&P; 500 ETF, for example, charges just 9 basis points, or 0.09%, per year in expenses, compared with 18 basis points for the Vanguard 500 Index fund. But that edge of $9 per $10,000 invested could be negated by a single trading commission, Traulsen noted.
The bottom line: For “the typical buy-and-hold investor socking away $200 a month, there’s no advantage” to ETFs, Traulsen said. “Their use is limited to those willing to pay up for the privilege of trading frequently or immediately, or those who make one big lump-sum investment and then refrain from trading,” he said.
What’s more, though most ETFs have paid out little in capital gains, many of them have short histories. And already there have been notable exceptions: Barclays’ Canada and Sweden ETFs paid out massive capital gains last year, for instance--just as many traditional mutual funds did.
Regardless of their shortcomings, some investors say the convenience of ETFs makes them better choices than alternatives.
Mike Freeman, an investor in Wichita, Kan., said he uses ETFs tracking the large-cap S&P; 500, the S&P; mid-cap 400 and the S&P; small-cap 600 as his core holdings. He likes knowing that he could quickly shift assets from his S&P; 500 shares into a money market fund if he wishes.
“In the scheme of things, the commission is nothing,” Freeman said. “If I’m on a boat halfway to Johannesburg, I don’t want to have to worry about doing business with a mutual fund company that might want to handle [purchases or redemptions] by mail.”
Possible Growth Areas
The ETF industry’s latest growth spurt was sparked by Barclays’ roll-out in May 2000 of its domestic iShares lineup of 40 funds. Today, there are 85 ETFs in all, as well as 18 Merrill Lynch HOLDRs, which are stock-basket depositary receipts similar to ETFs. HOLDRs represent direct ownership in the individual underlying stocks rather than in a fund, Merrill says.
With about 70% of ETF assets concentrated in Spiders and Qubes and most of the major stock index bases now covered, analysts say the industry is saturated to some degree.
“Without question the growth is slowing,” Rollenhagen said. “It’s natural. The industry is catching its breath and striving to avoid sector saturation.”
But there are plenty of possible growth areas, he said, including bond ETFs for the domestic market, and ETFs to be sold abroad.
Actively managed ETFs are an intriguing possibility, Rollenhagen said, if they pass legal muster. Barclays and competitors including State Street Global Advisors and Nuveen Investments are awaiting a ruling on the concept from the Securities and Exchange Commission.
Actively managed ETFs, in theory, could replace so-called closed-end mutual funds. The perennial problem with closed-end funds is that their share prices can trade far above, or far below, the true value of their holdings.
But portfolio disclosure is one of the main concerns with the actively managed ETF idea. The portfolio transparency that comes with index ETFs spurs arbitragers to keep the shares priced in line with the indexes they track, but that kind of up-to-the-minute disclosure would make active managers cringe.
For now, new ETFs are aimed at “accessing narrower slices of the market” and helping people “finish out their portfolios,” said Lee Kranefuss, head of Barclays’ individual investor group.
On Friday, Barclays launched ETFs tracking three subsectors of a Goldman Sachs tech-stock index. This week, it plans to launch ETFs based on the Russell mid-cap index and its growth and value subsets.
Independent financial advisors, a key driver in the growth of ETFs in recent years, pushed for the mid-cap products, Kranefuss said.
Mark Wilson, a financial planner with Tarbox Equity in Newport Beach, said he sometimes uses Qubes and Spiders for investors in taxable accounts, but steers clear of narrower sector ETFs that he says can be especially volatile or can have a high tracking error between the share price and the underlying index.
Still, analysts say ETFs based on niche indexes, or variations on established indexes, could continue to fuel growth.
“There’s always another twist,” Rollenhagen said, noting that Nuveen plans an ETF based on the “America’s fastest-growing companies” index created by Individual Investor Group.
Vanguard Group, which launched its first ETF in June as a “Viper” share class of its Total Stock Market Index fund, sees ETFs as a way to keep both rapid traders and the firm’s traditional buy-and-hold investors happy, said spokesman Brian Mattes.
Meanwhile, State Street plans to launch more than a dozen ETFs for investors in Europe, Japan, Singapore and Australia later this year as firms increasingly target overseas investors.
Regardless of future growth, ETFs already are providing healthy competition for traditional mutual funds, Traulsen said.
“Hopefully, ETFs will force mutual funds to reduce expenses, maximize tax-efficiency and disclose their portfolios more frequently,” he said. “That would be quite a benefit for investors.”
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Times staff writer Josh Friedman can be reached at josh.friedman@latimes.com.
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Popular ETFs: A Sampling
Here are specifics on some of the exchange-traded funds that have become popular with investors. All of these securities trade on the American Stock Exchange. However, starting later this month, the New York Stock Exchange also will begin trading the Nasdaq 100 fund and some others.
Ticker Friday ETF Index sector symbol price DJIA Diamonds 30 Dow stocks DIA $105.68 iShares MSCI-Japan Japanese stocks EWJ 9.79 iShares MSCI-U.K. British stocks EWU 15.37 iShares Russell 2000 2,000 smaller stocks IWM 97.80 iShares S&P; 500 500 blue-chip stocks IVV 122.00 iShares S&P; 600 600 small-cap stocks IJR 112.70 Nasdaq 100 Major Nasdaq stocks QQQ 43.15 Select Tech Spider Major tech stocks XLK 27.34 S&P; 500 Spider 500 blue-chip stocks SPY 122.24 S&P; 400 Spider 400 mid-cap stocks MDY 93.44 Source: Prudential Securities, Times research
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ETFs at a Crossroads
The pace of growth among the nation’s exchange-traded funds has tapered this year after booming in the late 1990s and in 2000, when Barclays Global Investors rolled out its iShares ETF lineup.
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Number of ETFs
2001 (year to date*): 85
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ETF assets
2001 (year to date): $72.7 billion
*As of May 30
Sources: Strategic Insight, Investment Company Institute
