There has been nothing new in finance in the last fifty years – except exchange-traded funds. Exchange Traded Funds, or ETFs, combine many of the best characteristics of stocks and mutual funds.

ETFs are index funds that trade on a stock exchange. Like a mutual fund, they represent a collection of stocks, but unlike a mutual fund, they trade throughout the day like a stock. This is similar to a closed-end fund, but unlike a closed-end fund, ETFs do not have a limited number of shares and they trade very close to their underlying net asset value.

The first, and still one of the most popular is SPY, representing the Standard & Poor’s 500 Index, which began trading in 1993. It is called a “spider” based on the first initial of its official name: S&Ps Depositary Receipts.

“Authorized participants,” usually between 20 and 30 large brokerage houses, “make” markets in ETFs. Arbitrage trades by these participants narrow the gap between ETF market prices and the net asset values of the indexed shares. Financial companies hold shares of the stocks in the index in a “trust.” One such bank is the State Street Bank & Trust Co. of Boston, which holds the Spiders’ shares. About 80% of the volume of trading in ETFs is generated by a small percentage of shareholders, including the arbitrageurs.

The market price of shares in the ETF indexes are recalculated every 15 seconds. The actual trades on the secondary markets are posted on the ticker tape.

Advantages

One major advantage of ETFs is their very low cost of operation, frequently half the annual expense of an index mutual fund, and considerably less than a “managed” fund. For example, the annual expense ratio for a foreign equity fund averages 1.92%. This is the highest for any category of fund. An index mutual fund will average 1.06%. But an ETF fund will range from .35 to .99 percent.

ETFs can be traded like stocks. They can be bought and sold any time during market hours. They can be margined. They can be sold short. They can be bought on limit price orders. Some have options based on their price.

ETFs are also very tax efficient. They seek to minimize capital gains by exchanging those stock that are being sold out of the index for those funds that are being added to the index. Because buying and selling in the fund is done by means of like-kind exchanges, it is not a taxable event.

Many mutual funds have $2,500 minimum for purchases, but investors can buy a single share of an ETF. Mutual funds must hold cash for redemptions, but ETFs hold little or no cash and therefore better match the performance of the index better. ETFs also have less paperwork than mutual funds, and do not charge 12b-1 advertising fees, as do many mutual funds.

Disadvantages

ETFs have a few minor disadvantages. Unlike open-ended mutual funds, ETFs cannot reinvest dividends. Dividends are paid out to owners of shares at the end of each quarter. This has a slightly adverse effect on performance and is called “dividend drag.”

Also, ETFs are capitalization weighted, similar to the indexes on which they are based. This shows up particularly in sector ETFs where one company might loom very large in relation to the index, such as Amgen does in the Biotech ETF, and the stock Ericsson in the Sweden ETF.

Purchasing ETFs incurs a brokerage commission just as a stock does. For small amounts where the brokerage charges would be a significant percentage of the investment, it would be better to use a no-load, no-transaction-fee mutual fund.

Prices of ETF trades are based on market forces, so a buyer might buy at a slight premium or discount. This difference between the price of an ETF and the price of the underlying net asset value is usually very small. When it drifts, arbitrageurs will step in and make a profit bringing the price back to net asset value.

Growing Popularity

ETFs are rapidly growing in popularity. New ETFs are constantly being created and most trade on the American Stock Exchange. Assets have also grown to $180 billion from $117 billion last year. Sixty billion dollars and half the ETFs listed on the American Stock Exchange are held by the iShares ETFs run by Barclay’s Bank Global Investors. Because of their advantages, the use of exchange-traded funds will continue to grow. Information on iShares can be found at www.ishares.com, and information on all ETFs can be found at www.morningstar.com.

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