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ETFs: The Greatest Invention Since Mutual Funds

By Ric Edelman

Allow me to introduce you to Exchange-Traded Funds. First brought to the market in 1993, this newest breed of investment company50 looks like a mutual fund but has important distinctions. Most important, you don't buy ETFs from a fund company; instead the shares are listed on a major stock exchange (hence its name) where they trade like other securities.

ETFs have six main advantages over retail mutual funds:

1)ETFs are dirt cheap. The typical retail mutual fund costs more than three times more than an ETF (the average annual expense ratio for mutual funds is 1.56% versus 0.40% for ETFs, according to Morningstar). ETFs are even cheaper than index funds, which cost an average of 0.70%. And the cheapest ETF charges only 0.07% - just one-tenth the average index fund fee and a tiny fraction of the average retail mutual fund fee. Retail mutual funds cost more because they issue monthly statements and provide other customer services. But ETFs trade like stocks, so the services that retail mutual funds typically provide are instead provided by the brokerage firm or the investor's financial advisor. By avoiding those tasks, ETFs avoid the expenses that go with them.

2) ETFs enjoy great tax efficiency. As explained on page 95, mutual funds engage in high turnover, which generates capital gains distributions - forcing investors to pay taxes. But ETFs generally engage in far less turnover (often zero). And even when there is some selling within the portfolio, it typically doesn't constitute a taxable event for investors. That's because ETFs benefit from a mechanism called in-kind redemption, which enables ETFs to redeem shares from baskets of their underlying securities. This avoids taxable distributions, saving the investor money on an annual basis.

3)ETFs disclose their holdings daily. With ETFs, you always know what you own. This is in stark contrast to retail mutual funds, which reveal their holdings only twice per year, in tardy filings and often only after considerable manipulation designed to mask what's really going on (see Window Dressing on page 100).

4)ETFs are priced in real time throughout the day. Mutual funds are priced only once per day, after the market has closed. When buying or selling mutual funds, you don't know the price until the next day. But ETF prices are quoted in real time all day long, just like stocks. Again, this is because ETFs trade on the open exchange.51

5)ETFs tend to be highly specialized. Retail mutual funds tend to hold securities that are individually selected by the fund's manager. These holdings change constantly, and the fund's holdings at any given moment can be (and usually are) eclectic. But ETFs typically hold only a certain kind of security - say, mid-cap growth stocks - and nothing else. They also tend to hold every security in that category; there's no manager trying to pick “which” mid-cap growth stocks to buy. Because this enables investors to own obscure assets that are otherwise too difficult or expensive to buy and monitor. For example, Barclays Bank offers an ETF that holds twenty-four agricultural, energy, and metals futures contracts. Instead of trying to monitor these twenty-four obscure instruments, an investor can merely track one ETF.

6)ETFs are favored by institutional investors. Barclays Global Investors, currently the largest issuer of ETFs, reports that 80% of trading in its funds is conducted by hedge funds and other big investors. When you invest in an ETF, you're investing alongside some of the nation's largest investors.

Did I say futures contracts? Indeed. ETFs can acquire, hold, and rebalance any pre-selected group of securities. The first ETFs tracked the S&P 500 Stock Index. But today, thanks to computer technology, you can create an ETF to track virtually any segment of the financial markets. Small manufacturers in the Southwest? No problem. Regional banking stocks? Fine. Aerospace and defense? Sure.

The ability to track specific segments of the market, without the influence (and inconsistencies) of fund managers, with insulation against the scams and abuses found in the retail mutual fund industry, with real-time pricing, dramatically lower costs, and greater transparency - all this explains why exchange-traded funds are so popular among professional investors.

Shortly after we completed our due diligence on ETFs and had decided to begin incorporating them into our clients' portfolios, a negative article appeared in a trade magazine. The July 2005 issue of On Wall Street, a publication written for stockbrokers, featured a cover story proclaiming, “Why Reps Have Soured on ETFs.”
That was a scary headline. Here we were, about to introduce ETFs to our clients, and now a major industry publication was saying that stockbrokers don't like ETFs. Why not?
“The fees on these products don't match those on mutual funds and that's giving many advisors pause . . . brokers don't have a lot of incentive to use ETFs . . . [although] for clients, the lower fees associated with ETFs provide a clear advantage to mutual funds.”
We knew we were on the right track.

No wonder ETFs constitute the fastest-growing segment of the investment world: Celent, a research and consulting firm, says ETF trading volume more than doubled from 2005 to 2006, and predicts that ETF assets will reach $2 trillion by 2010. Considering that ETFs hold only $422 billion in assets (as opposed to $10 trillion in mutual funds), 52 that's really saying something.

As ETFs become more widely available and more ubiquitous, and as consumers learn more about their advantages, ETFs will eventually surpass mutual funds in size and prominence in the marketplace. This is your opportunity to start now.

In the pages that follow, I'm going to help you create a highly sophisticated portfolio based on your personal goals and individual circumstances. Throughout this process, you'll receive an asset allocation model that is similar to those used by the nation's biggest and most powerful institutional investors. You'll have a portfolio that is far more diversified and sophisticated than you ever thought possible, and you'll be able to implement it very easily and at a remarkably low cost.

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50 Like mutual funds, ETFs are regulated by the Investment Company Act of 1940.
51 This also enables ETF owners to short their ETFs, buy them on margin, or purchase options. I don't endorse these ideas, but some investors favor these notions.
52 According to the Investment Company Institute, as of December 31, 2006. As if I was making all this up.