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Pennsylvania Investment Observer

Exchange-Traded Funds - Part I

by Judy L. Loy

June 4, 2004

Many investors and advisors (count me in) are tired of the shenanigans going on at several of the mutual fund companies, and for good reason. The mutual fund industry in general has been under fire of late because of late trading, breakpoint issues, and short-term trading of mutual funds. Yet, mutual funds remain an avenue for the small investor to stay diversified, save for retirement, and reach other financial goals. A fairly new kid on the block, exchange-traded funds (ETFs), is starting to make waves and gain in popularity, partially due to the mutual fund problems. Are the exchange-traded funds truly the new investment for the regular guy or gal on the street? First let's set out to clarify what an ETF is and the differences between them and mutual funds.

Exchange-traded funds have been around for years but recently big names have come out with new offerings, including Vanguard, and are gaining a lot of attention. ETFs are baskets of securities that are traded on an exchange, usually the American Stock Exchange (ASE or Amex). These securities trade throughout the day while mutual funds trade at their price once a day, 4 pm EST. This is a major difference between mutual funds and ETFs. Because ETFs trade throughout the day, similar to stocks, investors can use trading strategies used on stocks, such as shorting on margin (a rather risky strategy where the short investor is betting that the security price will go down).

Mutual funds (also called open-end funds) are bought and sold from their respective mutual fund families. When you redeem your shares of a mutual fund, you are getting the NAV value of your shares. NAV stands for Net Asset Value and represents the value of the underlying assets per mutual fund share. No-load funds are purchased and sold at NAV, but load funds are purchased at NAV plus a sales charge. In essence, mutual funds are always priced based on some form of their underlying asset value (the holdings of the mutual fund). On the other hand, ETFs can and do trade higher (at a premium) or lower (at a discount) to their net asset value. ETFs trade on the open exchange and their market prices are based on the laws of supply and demand rather than the actual underlying assets. There will be more on that in Part II.

A decided advantage to ETFs is their low underlying expenses. As compared to even the cheapest index mutual fund, exchange-traded fund's annual expenses are cheaper. The downside of ETFs is that you must pay a commission at a broker, just as you would for a stock transaction, to trade the shares. This makes it very difficult if not impossible for regular, small investments into ETFs. This is a disadvantage as compared to mutual funds, which usually allow monthly or quarterly automatic investments as low as $50. On ETFs, you might pay $50 in commission charges alone.

Exchange-traded funds have low underlying expenses because they are unmanaged. ETFs usually track an index, such as the S& P 500 or the Dow, or a specific sector, such as Biotechs or Software. Therefore, the securities in the ETFs are static unless a change occurs in the underlying index or security holding (split, merger, etc.). This puts the tax situation in favor of the ETF in comparison to a mutual fund, which is required to put through any capital gains on an annual basis. With exchange-traded funds, any changes within the ETF are generally not passed through to the ETF owner so you choose when to take the gain or loss by when you sell the ETF.

In this article I went over the generalities of exchange-traded funds and their differences from mutual funds. In next month's article (The first Wednesday of the month), I will go into detail on the specific ETF shares available and where to find more information on them.

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