Pennsylvania Investment Observer

Exchange Traded Funds

by Daniel J. Nestlerode

Wall Street rocket scientists are forever dreaming up new products they can sell to earn commissions. One of the earliest creations was mutual funds way back in the nineteen twenties. Mutual Funds have been a fabulously successful investment medium now valued in the trillions of dollars of market worth. There have been a number of much less successful product launches, unit investment trusts for example. But now the boys on Wall Street seem to have another big time winner on their hands, exchange traded funds or ETFs as we call them.

Started in the late nineteen nineties, ETFs have grown in recent years to a market value of over $150 billion, represented by 184 different funds according to William O'Neil's (of Investors Business Daily fame) on line investment database. New funds are being created weekly and I expect the offering to soon number over two hundred funds.

ETFs can be subdivided into several sets including (1) country funds, (2) index funds, (3) sector funds, (4) bond funds and what I call (5) regional funds. Country funds following the performance of the investment market in a particular country, such as France. Index funds track one of the many averages of stock prices here in the United States. For example there is an ETF that follows the Dow Jones Industrial Average, called a diamond. Sector funds follow specific industry groups, such as transportation stocks, computer stocks, or financial stocks. These ETFs are usually made up of a handful of leading stocks within a particular industry or market sector. Finally what I call Regional ETFs are those that are multicountry offerings, covering all of Europe's markets or the all Far Eastern stock markets except Japan's market for example.

ETFs are traded just like stocks on the stock markets and are created, managed and offered by some of the major investment firms, including Barclays Bank, Merrill Lynch and the Vanguard Group among others. Each firm offering an ETF has a slightly different twist on the particulars for their ETFs, so I recommend that you get the prospectus from the ETF or your broker before making any investment. Furthermore, just as with any security, all the usual caveats important to remember.

You might be wondering why ETFs are growing like bad weeds. There are three major reasons in my estimation. First, you can trade ETFs just like stocks. Mutual Funds however can be bought or sold once a day. So ETFs are more flexible from a trading standpoint. Second, ETFs are usually less costly to manage and run than mutual funds, so that the costs of operation are fairly minimal to the investor. But probably most important, ETFs are not part of the breakpoint fiasco brought on by the mutual fund industry and the regulators. Deciding which share class of a mutual fund to buy is akin to buying an airline ticket. The complexity of the purchase is driving brokers and investment advisors away from mutual funds and right into the waiting arms of the ETFs.

We are using EFTs to gauge the performance of various subsets of the stock market and to provide small portfolios with instant diversification, but not over diversification. As portfolio managers, ETFs are filling a void between mutual funds and individual stocks. Look for them to be more important in the future.

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