Chapter 21. Exchange-Traded Funds

We start with the alternative that probably is best known to investors because of the press coverage it has received. Many investors have no doubt heard specific ETFs talked about, such as Spiders and Qubes, without realizing they are ETFs and without knowing exactly how they work.

An ETF is a hybrid security, part index fund and part stock. It resembles an index mutual fund, but trades like a stock, primarily (to date) on the American Stock Exchange. In effect, it is a new form of index fund, tracking some sector or index or investing theme, that trades on an exchange like a stock.

ETFs consist of a basket of stocks that track an index or sector, and can be classified accordingly : They can track a broad-based index, track a sector, or be international in scope. Examples include the following:

• Standard and Poor's Depository Receipts ( Spiders ) track the S&P 500 Composite Index.

• Diamonds track the Dow-Jones Industrial Index.

• Vipers track the Wilshire 5000 Index, the most comprehensive market index in the United States.

• The most popular ETF, based on volume of trading, is the Qube (so named because of its ticker symbol, QQQ), which holds the stocks in the Nasdaq-100 Index, and is a popular play on active Nasdaq stocks.

One of the best known ETFs is the Spider, introduced in 1993 to reflect the S&P 500 Index. The S&P 500 Index is one of the best known market indexes, used extensively by professional investors as a benchmark. Spiders are traded on the American Stock Exchange, are priced continuously during the day, can be sold short, and can be purchased on margin. More details on some of these ETFs are provided later in this chapter.

All of these funds trade on the exchange like any other stock. The American Stock Exchange has been, and continues to be, the leader in this area. ^[1] In fact, approximately 75 percent of the volume on the American Stock Exchange comes from the trading of ETFs. However, this situation is now changing, with the New York Stock Exchange planning to offer more and more ETFs. Having started trading Spiders, Diamonds, and Qubes in July 2001, as of April 2002, the NYSE began trading 27 additional ETFs, with plans to offer even more in the future.

^[1] All ETFs originally traded on the American Stock Exchange, but iShares S&P 100 trades on the Chicago Board of Exchange and iShares S&P Global 100 trades on the New York Stock Exchange.

Investors can transact in ETFs throughout the trading day, unlike mutual funds, which are priced once a day. Generally, the share price trades very close to the NAV.

What happens when an investor wishes to sell his or her ETF? Unlike a mutual fund, where the shares must be sold back to the fund, the shares of an ETF are simply sold to another investor, thereby having no direct effect on the fund. As a result, it is important to ensure there is adequate liquidity in the form of trading volume (at least a few thousand shares traded daily).

Recall from Chapter 2 that a closed-end fund can, and often does, sell at a discount to the NAV of the fund, meaning the price of the shares is less than the NAV of the fund. ETFs, on the other hand, have devised an unusual process to ensure that the shares always sell for approximately the value of the portfolio holdings. ^[2] This is accomplished by granting special trading rights to institutional investors interacting with the ETF company. ^[3]

^[2] If the ETF share price is less than the actual value of the underlying assets, an institutional investor can buy the ETF shares and turn them in to the sponsoring company for an equivalent amount of the underlying stocks, which the institution then sells for an immediate profit. If the ETF share price is greater than the underlying assets, the process is reversed . This unique process essentially ensures that the price of the ETF shares will approximate very closely the value of the underlying assets.

^[3] ETF companies include the Bank of New York, Merrill Lynch, Barclays Global Investors, State Street, and Vanguard.

The in-kind process involving special trading rights for institutions also leads to some tax efficiency. Redemptions do not involve the fund at all, but rather one investor selling to another. The ETF manager does not have to sell shares to pay for redemptions; therefore, redemptions do not create capital gains that must be distributed to the shareholders. Although both index mutual funds and ETFs avoid capital gains as a result of no active trading, the ETF also avoids redemptions and the capital gains that could result from this activity.

Note, however, that ETFs might still distribute capital gains as well as income as a part of holding a particular set of stocks. Contrary to what many believe, ETFs can make taxable distributions because they are required to pass along all net realized capital gains and dividends to shareholders, which is exactly what mutual funds have to do. Some ETFs are set up to make dividend distributions. Spiders, for example, are designed to provide investment results and pay quarterly dividends that correspond to the underlying indexes' component stocks.

In fact, many ETFs hold securities that pay dividends, and these dividends have to be distributed. However, underlying expenses are deducted from the dividends before any distributions. Of course, some will hold portfolios of securities where dividends are much less likely. The Nasdaq 100 Tracking Stock is a good example ”the stocks in this portfolio are much less likely to pay dividends.

Without any portfolio turnover , and with the ability to redeem shares in kind with actual securities, an ETF would not earn much in the way of distributable capital gains. This is exactly the case for some well-known ETFs, such as the Spiders. Although the Spiders have paid dividends each year, they showed no long-term or short- term capital gains for the years 1997 through 2001.

However, such is not the case for some other ETFs. They must sell securities when a company no longer qualifies to be in the index that the ETF is tracking. For example, the MidCap Spider tracks the S&P Midcap 400 index. When a stock is removed from this list because it is no longer a midcap stock, the ETF may have taxable distributions. In fact, the MidCap Spider had a capital gains distribution of $2 per share in one recent year.

We know that index funds have much lower operating expenses than actively managed funds because they are passively managed. ETFs have even lower expenses. Whereas the average domestic stock index fund charges about 1.50 percent a year, the average ETF charges about 0.34 percent. The investment company is responsible for the index fund and sending investors statements, but a brokerage firm does that in the case of ETFs, leaving the fund itself with very low expenses.

As of the end of 2001, of the approximately 100 ETFs, about one third were domestic broad-based funds, about one third were domestic funds devoted to specific industries or sectors, and about one third of them were global or international funds. Most of the industry's assets are in the domestic broad-based funds. The global or international funds had captured only a very small portion of total assets by the end of 2001.

As of the end of 2001, the assets of all ETFs totaled some $83 billion, up from $58 billion at the beginning of the year, but no direct threat to the enormous size of the mutual fund industry. Figure 21-1 shows the assets of equity mutual funds (as opposed to all mutual funds) versus the assets of all ETFs, as of year end 2001. By early 2002 there were approximately 120 ETFs. A complete list is available at www.bloomberg.com/personal.

Figure 21-1. Assets of Equity Mutual Funds versus Assets of ETFs in 2001, Billions of Dollars.

More changes are on the way. During 2002, fixed-income ETFs are expected to be introduced. The initial ones will be based on well-known bond indexes from Lehman. Others will be available based on Treasury bonds with one-, two-, five-, and 10-year maturities.

Investors can learn about ETFs at several Web sites, including the following:

• Amex.com. The American Stock Exchange is the home of almost all ETFs, and it carries extensive information about them.

• Morningstar.com. Exactly as it is a source of information about mutual funds, so too is Morningstar an information source about ETFs.

• Barra.com. This site has extensive information about many of the indexes that ETFs are designed to track.

• Exchangetradedfunds.com. This site is devoted to ETFs exclusively, with a section on news and ETF products, among others.