Fortune - ETF's...ETF futures next?
Exchange-traded funds have revitalized the industry and attracted billions from investors. Which one is best for your portfolio?
Lee Clifford
ETFs can be ideal for plugging holes in your portfolio If you want to ... Then consider ...
Get broad market exposure through an index
Barclays iShares or Standard & Poor's SPDRs. Both are cheaper and more tax-efficient than traditional S&P index funds.
Diversify a portfolio and cut your exposure to tech stocks
iShares S&P Small Cap 600 or Russell 1000 Value. They have lower technology weightings than the major indexes.
Focus on a particular slice of the global market
Sector and country ETFs. They let you buy a collection of stocks, or an entire index, with one transaction.
If you've watched any non-Tivo TV lately, you have no doubt seen the omnipresent Barclays commercials for exchange-traded funds, or ETFs. In one spot a well-dressed woman prowls a high-end store and picks up a bar of Scottish Mist soap. Her eyes widen when she sees the label: made in south korea. Auntie Mae's Old American Chocolates? Also made in South Korea. Tasty Traditions Matzo Ball & Soup mix? Ditto. Then comes the tag line: "Spotted a trend? Buy it."
You might say the same thing about ETFs themselves. Traded under quirky names like Spiders, Cubes, and iShares, ETFs let you purchase baskets of stocks—meaning specific indexes, sectors, or countries—with a single transaction. In one fell swoop you can buy or sell a U.S. real estate index, an array of wireless stocks—and, yes, even the brunt of the South Korean stock market.
Since these new stock/fund hybrids were introduced on the American Stock Exchange in 1993, interest has exploded to the point where they're now giving traditional funds a run for their money—literally. Some 94 different ETFs currently trade on the Amex, totaling about $80 billion. And in December cash flowing into ETFs nearly equaled mutual fund inflows, according to the Investment Company Institute. Says Cliff Weber, senior vice president of new-product development at the Amex: "They've doubled in assets and in volume every year for the past four or five years, and we think we're still in the very early part of the growth phase." (See also "Along Came the Spiders" and "Cube Stake: Why the Nasdaq 100 Sizzles," in the fortune.com archive.)
That success stems from the major structural advantages that ETFs have over old-fashioned index funds. For starters, they trade throughout the day, just like stocks. (By comparison, you can only buy or sell mutual fund shares each afternoon at the market close, when the fund reprices its holdings.) You can also buy ETFs on margin and, in most cases, sell them short. Plus, these new entities are less expensive to run, meaning lower management fees. Barclays' S&P 500 iShares, for example, siphon off just nine basis points, or 0.09% of the value of your investment. The equivalent Vanguard 500 Index fund—one of the cheapest mutual funds around—has an annual expense ratio of twice that. But be warned: Every time you buy an ETF, you pay a trading commission. So if you're flipping them like pancakes, it will cost you.
ETFs also have a bigger advantage when it comes to tax efficiency (something you'll appreciate if any of your mutual funds lost money in 2000 and then stuck you with a taxable distribution). When investors redeem shares in a standard fund, the manager is often forced to sell stocks that have appreciated in order to raise cash. That triggers a capital gains hit for the remaining investors, even if the fund finished down in a given year. However, ETF redemptions are just like selling stock, so you won't get hit with capital gains taxes when other investors cash out. "If you're going to take a passive approach [to investing], your only alternative is an index fund," says Robert Levitt, a financial planner based in Boca Raton, Fla. "But ETFs are cheaper, easier to trade, and more tax efficient."
Having said all that, these new financial instruments are still very much a work in progress. Many of these baskets only recently began letting people reinvest their dividends, and they aren't set up for dollar-cost averaging (investing the same amount periodically), meaning investors who want to stash away $100 every two weeks would be better off in a no-load mutual fund, where they don't have to pay broker commissions. There have also been some red flags raised about liquidity for some of the newer, more sparsely traded issues, a complaint that ETF boosters are quick to contest. "People say they're illiquid because they don't see very many shares trade, but as long as they're created with underlying stocks that do trade, it's a nonissue," contends Levitt. That may be true for an S&P 500 basket, but don't count on the same liquidity with the Korean Kospi.
By their nature, we should add, some ETFs are more tax-efficient than others. You'll still have to pay taxes whenever an index is rejiggered, forcing a manager to sell stocks that have been dropped. That can lead to a distribution—and capital gains—that you can't control. While the S&P 500 is recomputed only a few times each year, stocks are constantly outgrowing small-cap and value indexes, meaning managers have to sell those companies to keep their portfolios in line.
The tax issue with foreign indexes gets even more complicated. Why? Fund administrators labor under SEC requirements that force them to sell off a company whose share of the index gets too large (for example, Nortel on the Canadian market). Several foreign iShares baskets, in fact, have already paid out unexpected capital gains distributions because of this, to predictably irate shareholders.
Finally, there is such a thing as overkill, say some financial planners, who would be loath to put their clients' money into, say, an e-commerce basket or one that tracks the Malaysian stock index. "Some of the providers are getting a little out of hand," says Chris Cordaro, a financial planner at Bugen Stuart Korn & Cordaro in Chatham, N.J. "Do we really need to segment the market that much?"
Weighing all these attributes—the good and the bad—we culled through the current ETF offerings to find those most useful to a typical portfolio. We found three specific uses for them: tracking major indexes, rebalancing your portfolio, and getting exposure to a remote corner of the market. Here are the best baskets for each.
T racking a broad index: You make no bones about it—you can't beat the market (or even stomach it), and you don't want to waste your time trying. Tracking the major indexes with an ETF, then, may well be the way to go. Financial planner Levitt, for example, simply won't put a client with a lump sum to invest in a regular index fund anymore. Which one should you buy? It depends, naturally, on how much of the market you want to cover. The broadest, and most conservative, option is the Barclays iShares Russell 3000 (Ticker: IWV), which includes the largest 3,000 U.S. companies ranked by market cap—exposing you to 98% of the investable equity market. If you'd rather stick to the heavyweight Dow Jones Industrial Average, State Street offers Diamonds (DIA). Those wishing to track the S&P 500, though, have two fairly straightforward choices: Barclays iShares (IVV) and State Street's SPDRs (SPY). Barclays' large-cap offering is slightly cheaper, but Spiders have the big plus of having paid just one tiny capital gains distribution in seven years. (The iShares hit investors with a big one right after launching last year—not an auspicious move.) In terms of popularity, however, nothing comes close to the Bank of New York's Cubes, which track the Nasdaq 100 (QQQ) and are by far the most heavily traded ETFs. The benefit is that they let you invest quickly in virtually every blue-chip tech stock around. The problem is that you still have to figure out which way—up or down—to place your bets. "Right now," says Levitt, "we're shorting them."
Incidentally, you're likely to see big fund companies fighting back in the coming months by adding cheaper share classes to their own index funds. Vanguard, for instance, is currently working to launch its brand of ETF, called Vipers, by the end of March, and the company has already added a new "Admiral" share class, offering lower expense ratios for longtime investors with hefty accounts.
To balance your portfolio: Still tech-heavy? Haven't seen a small-cap stock in years? ETFs can be a quick way to get your portfolio back into shape. Cordaro likes Barclays iShares S&P 500/BARRA Growth (IVW) and Value shares (IVE), which segment the 500 companies into those two traditional investment categories. "We'll often buy the Value shares for clients who have a ton of tech stocks," says Cordaro. For exposure to smaller companies, Barclays has products that track the small- and mid-cap S&P indexes, and State Street offers StreetTrack baskets that follow the Dow Jones Small Cap Growth and Value indexes (DSG, DSV). But as we cautioned above, don't expect the same degree of tax efficiency in this category, because of the underlying churn of fast-growing companies. Though ETFs are still better than most comparable index funds on this count, that doesn't solve the basic problem. Sure, you want each company to become a growth company, but if it does, it gets kicked out, and you'll wind up with incrementally higher taxes.
To get exposure to a fast-moving corner of the market: ETFs can also be a shot in the arm—something to buy if you want specific, concentrated exposure to a country or sector on which you feel particularly bullish. iShare varieties come in a range of flavors, from health care to real estate, and you can even buy ones that track 21 of the most popular Morgan Stanley Capital Index countries. Levitt recently bought iShares Japan (EWJ) for a client who was convinced that that country would perk up but didn't want to bet on individual companies. Overall, however, financial advisors tend to be less enthusiastic about these types of ETFs, simply because the whole point of index investing is to avoid picking stocks or sectors. "We usually don't like to get that specific," says Cordaro.
That's also why the experts we spoke to weren't too hot on HOLDRS, another type of ETF marketed by Merrill Lynch. The company took popular sectors like broadband and wireless (yes, this was 1999) and put together portfolios of 20 stocks for each. But the portfolios don't have discretionary managers at the helm, and the stocks never change. So if a stock grows or slides too fast, there's no one there to manage a reallocation. Second, HOLDRS come only in blocks of 100 shares, making them too expensive for many investors.
But perhaps the biggest buzz these days is about Barclays EAFE basket, which is expected to launch this fall and will track Morgan Stanley's Europe, Australasia, and the Far East index. "It's going to be the first way to get broad international exposure in one place," Levitt says. In other words, U.S.-based international funds are about to get a run for their money too. |
