Mutual fund review: Exchange-traded funds surge in popularity

A popular financial maxim warns against investing in things you don't understand.

But one of the mutual fund industry's fastest-growing investment options is also poorly understood by investors.

That option — exchange-traded funds — caught fire in 2010. Thanks to a flood of new money from investors, plus rising stock prices, the value of assets in ETFs surged 43% last year, topping $1 trillion for the first time, according to research firm Morningstar Inc.

By comparison, assets in traditional mutual funds rose only 13% in 2010. As a result, at the end of the year, ETFs held more than 10% of total mutual fund assets.

For individual investors, ETFs are attractive in part for the same reasons traditional index funds are. That's because a typical ETF is designed, like a conventional index fund, to track the performance of an index of stocks, bonds or other instruments.

That means ETFs, like other index funds, have lower costs than funds run by managers who trade actively to try to beat the market. Another common advantage is the certainty of an investment return that's close to that of the index being tracked. In other words, no nasty surprises caused by a fund manager's erroneous hunches.

"For investors today who have been through a tough 10-year period, who say, 'I don't want to underperform the market or pay an extensive amount of fees, all I want to do is perform in line with the market,' ETFs are the perfect vehicle," said Tom Lydon, founder of money management firm in Irvine.

The largest ETF, in fact, is the SPDR S&P 500, which tracks the broad-based Standard & Poor's 500 stock index and had $90 billion in assets at the end of 2010. The concept is relatively easy to understand.

Still, a surprisingly high number of investors say they don't understand ETFs. A survey last month by Chicago market research firm Mintel showed more than 60% of investors don't buy ETFs because they "don't know what they are," and even many investors in the products say they don't fully understand them.

A likely reason for the puzzlement is that many of the 1,100 ETFs on the market focus on specific sectors. They are geared toward sophisticated investors such as hedge fund managers who like the ability to move in and out of market sectors easily and quickly during the trading day, without waiting for the end-of-day pricing of a traditional mutual fund's shares.

But many such ETFs tend to specialize in risky, often esoteric areas such as commodities, currencies or emerging markets. These funds also sometimes carry added risks that investors should be aware of, experts say.

"When you deviate from the plain-vanilla equity or fixed-income products, you have to beware of the nuances and the way these products behave under different market conditions, because they're not necessarily as straightforward as you might think," said Jim Pacetti, president of consulting firm ETF International Associates Inc. in New York.

One example: The price of crude oil has shot up 160% in the last two years from the depths of the financial crisis. Yet an ETF called United States Oil, which is designed to track the price of crude, is up only 14% in that period.

When oil prices rise, the cost of futures contracts that the fund buys also climbs, greatly reducing potential gains.

Many investors in the fund have complained that they were "blindsided when the performance doesn't match the expectations," said Ray Allen, the fund's manager.

"I get called all the time," Allen said. "A lot of times I get calls from brokers who don't know how it works and [they say] 'now I'm getting hammered because [customers] are not happy.'"

ETFs have several advantages for individuals.

One is cost. Management expenses incurred by ETFs typically are in line with those paid by traditional index funds and are much lower than many actively managed funds.

Another benefit is so-called tax efficiency.

During bear markets, traditional mutual funds can experience a high level of redemptions, forcing the fund to sell securities to raise cash to pay off departing shareholders.

More than that, it can saddle remaining shareholders with hefty capital-gains taxes. If the securities being sold were bought years ago when prices were lower, as is often the case, shareholders who aren't pulling out their money must pay taxes on the capital gains much earlier than they would have to otherwise.

ETFs typically avoid that problem because investors who decide they no longer want to hold that fund simply sell their holdings on an exchange. The ETF isn't forced to unload assets.

Another advantage: Diversifying your portfolio is easier with ETFs than it is with individual stocks.

Rather than buying a single stock in a desired sector, an investor can make a broader bet through a sector ETF. That could limit a gain if the stock outperforms the sector. But it provides protection if the stock falters while the rest of the sector advances.

Beyond that, ETFs give small investors entree to areas of the financial markets that previously were difficult for them to access, such as gold and other commodities, currencies and some international markets.

But when buying narrowly focused ETFs, investors need to pay attention to the difference in performance between the fund and the index it is designed to track.

No fund perfectly tracks its index because management expenses typically reduce the fund's return. But so-called tracking error also can be caused by the way fund companies construct their portfolios.

This is shown through the performance of two funds that track the same index.

Over the last five years, the MSCI emerging markets index gained an average of 12.78% a year, according to Morningstar. The Vanguard Emerging Markets ETF returned 12.2% a year in that period. Its rival, the iShares MSCI Emerging-Markets ETF, gained only 11.9%.

The difference is partly explained by fees. The expense ratio of the Vanguard fund is 0.27%. For iShares, it's 0.69%.

Another explanation is that Vanguard holds more securities than its rival — 887 compared with 769 held by the iShares fund, which excludes smaller and more thinly traded stocks.

Winnowing the number of stocks in the portfolio typically improves a fund's liquidity, but can cause a fund to diverge from its benchmark index. The number of stocks held by the iShares fund is actually up 300 in the last 18 months, a move the fund made in part to address its tracking error.

Deviating from a benchmark is not always bad. In a down year, a fund with a looser correlation to the index can outperform it — in other words, post smaller losses.

In the 2008 bear market, the iShares fund slumped 50%, better than the 53.3% drop in the index.

Not surprisingly, investors often become aware of tracking error only when their funds underperform their indexes.

"Individual investors are aware of it when it comes up and slaps them in the face," said Joel Dickson, an ETF strategist at Vanguard.

Finally, investors in international ETFs, as well as in some corporate and high-yield funds, should keep an eye on so-called premiums and discounts.

A premium is how much an ETF's share price exceeds the market value of the underlying securities in the benchmark index. If the ETF price exceeds the value of the securities, an investor would pay a premium to buy the fund, and vice versa.

Investors can check the value of the underlying securities at any time by looking up their "indicative" value, which is updated every 15 seconds and available on fund company websites. They're also available on Morningstar's website by typing .IV after a fund's ticker symbol.

Gaps in the prices of ETFs and their underlying securities usually are corrected by the companies that oversee the ETFs. To correct a premium, for example, the company puts new ETF shares on the market, lowering the market price and aligning it with the value of the underlying securities.

Nevertheless, some funds can run premiums or discounts for lengthy periods. For example, some hot funds tend to have premiums.

An investor shouldn't necessarily shy away from buying a fund selling at a premium, experts say. But an investor making a short-term trade should pay special attention to a fund's daily trading patterns to avoid buying when there's a large premium, said Michael Iachini, managing director in the investment advisory unit at Charles Schwab Corp.

"If you don't understand the costs involved — and for ETFs, that includes discounts and premiums — you could wind up very unhappy with your returns," Iachini said.

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