What Are Exchange Traded Funds?

When most people think of
stock funds, they think of mutual funds. But a new class of stock
funds are growing in popularity, thanks to powerful advantages that
deserve your attention.

Exchange-traded funds offer
the diversification of index mutual funds by spreading your invested
dollar among the stocks of many different companies. But ETFs hold two
key advantages over their traditional cousins.

First, ETFs operate under
the same tax rules as mutual funds, but the ETFs have figured out a
way to avoid distributing capital gains. This makes ETFs worthy of
consideration, not only for the trader but for the long-term investor
as well. How ETFs accomplish this requires a somewhat technical
explanation. But the upshot for you is that ETFs don’t incur
capital-gains taxes once a year like mutual funds, because they have
no taxable gains to distribute.

You become subject to
capital-gains taxes only when you sell your ETF shares at a price
above your purchase price. In that regard, ETFs act just like stocks.
ETFs do, however, have to distribute cash dividends, just like mutual
funds, and these distributions are taxable. More on this later.

Second, as the name implies,
exchange-traded funds are bought and sold, and priced and repriced
throughout the day in the financial markets. These “tradable
funds” are quoted in the financial markets just like stocks,
their bid and ask prices adjusting throughout the day, in response to
supply and demand.

That amounts to a major
departure from mutual funds. Take the Vanguard 500, the index mutual
fund that tracks the S&P 500 index. Throughout the day, the stocks
that make up the index trade and change in price, and the S&P 500
fluctuates accordingly.

But the net-asset value of
the Vanguard 500 changes only once a day. At the end of each trading
session, the mutual fund companies rush to recalculate the Net Asset
Value of their fund shares based on the closing prices of those funds’
holdings, net of fund expenses.

This makes open-end mutual
funds useless to the short-term trader who might want to play an
intraday market move.

For example, let’s say a
trader is watching the trading action on the S&P 500. The index
dives in the morning, reflecting a market sell-off. Then cash
comes stampeding back into stocks, and the S&P reverses and starts
to come off the lows.

A short-term trader who
figures out the S&P is beginning a big one-day bounce couldn’t use
the Vanguard 500 to play the move, because his purchase price would
reflect the S&P’s market close, not the index level at the time he
entered his buy order.

“With mutual funds, you
get that day’s closing price,” said Jim Novakoff, a designer of
portfolio models for institutions and partner of Levitt, Novakoff, a
Boca Raton, Fla.-based investment firm. “Now there are some
complications, because not all funds close at the same time. In some
cases, you need to have the trade done by 3:00 p.m. to get that day’s
closing NAV. Sometimes, it is 4:00 p.m. or 5:00 p.m.”

On the other hand, you could
take advantage of the same hypothetical opportunity using Standard
& Poor’s Depositary Receipts (SPY),
a tradable fund listed on the American Stock Exchange. SPDRs, or
Spiders, trade throughout the day. You’re in your Spiders at their
share price at the moment your order executes.

The similarities with stocks
don’t stop there. Because they trade on exchanges like stocks, you can
buy tradable funds on margin, meaning you borrow from your broker to
increase your holdings. You can short exchange-traded funds just like
stocks. In other words, you can borrow ETFs from your broker and sell
them in hopes the share price will decline. If you’re right, you buy
back the same number of shares, then pay back the loan at a lower
price, pocketing the difference as a capital gain.

Tradable funds also entail
no front-end or back-end loads and no redemption fees, costs that can
eat away at the trader’s profit margin. However, you must pay a
brokerage commission to buy or sell ETF shares, just as you would to
buy or sell stocks.

ETFs also pose two other
disadvantages that you should consider before deciding whether they
suit your purposes vs. other trading or investing instruments.

Like stocks, you will
encounter “slippage” if you trade ETFs. To understand
slippage, you must understand the bid-ask spread. If you buy a listed
security (like an ETF or stock) through a normal brokerage account,
you will pay the lowest price offered by the current sellers. This is
called the “ask” or the “offer.” If you sell a
security, you will sell to the buyer bidding the highest price for
that security.

For instance, the highest
buyer may bid 20 1/2, and the lowest seller may ask 20 3/4. So the
bid-ask spread would be 20 1/2 to 20 3/4. Any stock price you see as a
buyer is different from what a seller sees. The quarter-point gap
amounts to slightly more than 1 percent of the stock price to the
buyer or seller. This cost is called slippage.

Another disadvantage regards reinvestment. Your mutual fund can use
cash dividends of its stock holdings to acquire more stock and more
fund shares for the fund shareholder. ETFs like Spiders and Diamonds
do not offer this reinvestment option. Instead, they pay out quarterly
cash dividends from the accumulated dividends of the underlying
stocks.

In this regard, mutual funds
hold the advantage. You can sidestep the brokers and establish
accounts directly with the mutual fund families, avoiding commission
costs (but in many cases incurring load and/or redemption fee costs).

The pioneer of ETFs is the
American Stock Exchange. As of the end of February 2000, the Amex
listed 34 distinct ETFs for trading. For discussion purposes, you can
break these down into four categories.

There are
“domestic” ETFs, as Novakoff refers to them. They include
the SPDRs (SPY),
which track the S&P 500; the MidCap SPDRs, which track the S&P
400; the Nasdaq-100 Index Tracking Stock (QQQ),
nicknamed the “Cubes,” based on the 100 biggest
non-financial Nasdaq stocks; and the Dow Jones DIAMONDS (DIA).

State Street Bank and Trust
Company of Boston, the administrator and custodian of the Spiders,
also has trotted out “Select Sector SPDR Funds.” These
instruments “unbundle” the S&P and give investors
ownership in particular industrial sectors.

These include Basic
Industries Sector (XLB),
Consumer Services Sector (XLV),
Consumer Staples Sector (XLP),
Cyclicals/Transportation Sector (XLY),
Energy Sector (XLE),
Financial Sector (XLF),
Industrial Sector (XLI),
Technology Sector (XLK)
and Utilities Sector (XLU).

Another Merrill Lynch HOLDR,
the Telebras HOLDR (TBH),
trades on the New York Stock Exchange. This financial product was
created in June 1998 to enable investors to trade in a single
transaction the 12 companies born from the breakup of Brazilian
telecom monopoly Telebras.

The Merrill Lynch HOLDRs
differ in an important respect from the other ETFs. Each HOLDR product
represents a fixed basket of 20 stocks, with the exception of the
Telebras HOLDR, which holds 12 companies. Once a HOLDR is created, its
component stocks are locked in. The index-based ETFs, however, drop
and substitute stocks to keep pace with their underlying indexes.

The HOLDRs trade in round
lots of 100 shares. Each round lot represents a fixed number of shares
in the component stocks. There is a way around the round-lot
requirement. “You can acquire shares in odd lots only if you get
the HOLDR from Merrill Lynch directly. Then you can get a split
share,” Novakoff said. “Apparently, ML bought some software
that allows them to track split shares.”

It also is possible to own,
through a single security, an interest in a basket of stocks tied to
the benchmark index of a foreign country. Have you a strong opinion
that one country may outperform the U.S. market in the short,
intermediate or long term? Consider World Equity Benchmark Shares,
WEBS.

As of the end of February 2000, the Amex listed WEBS that address 17
countries: Australia (EWA),
Austria (EWO),
Belgium (EWK),
Canada (EWC),
France (EWQ),
Germany (EWG),
Hong Kong (EWH),
Italy (EWI),
Japan (EWJ),
Malaysia (EWM),
Mexico (EWW),
Netherlands (EWN),
Singapore (EWS),
Spain (EWP),
Sweden (EWD),
Switzerland (EWL),
and the United Kingdom (EWU).

“In addition to ETFs’
tax advantages, it is possible for experienced, active traders to
implement index-based structured trading strategies with ETFs — a
personal hedge fund,” Novakoff said. “In fact, ETFs were
first designed for hedge funds. It is difficult and, in many cases,
impossible to implement hedge-fund-like structured strategies using
mutual funds. Mutual funds, on the other hand, have some important
advantages for long-term investing, including no brokerage fees and
direct contact with the fund company. Mutual funds are now the
instrument of choice for 401(k) programs, for example.”

For more information on the
Amex-listed ETFs, you can download
a prospectus from the American Stock Exchange.