For years, financial planners have pushed mutual funds as one of the best investment choices for small investors because of their diversification and expert management. But lately, investors are getting a fresh lesson from Wall Street.
Mutual funds can siphon off money just as easily as unscrupulous CEOs can. As the scandals in the $6.9 trillion mutual-fund industry continue to grow, some investors are dumping their funds and looking for alternatives.
One option proving to be popular is the exchange-traded fund (ETF). This is a diversified portfolio of stocks and bonds that tracks an index through computerized, or passive, management. ETFs are listed on the major stock exchanges and trade as if they were individual companies. In recent months, more and more personal-finance experts have begun recommending them.
"We like ETFs very much," says Mary Malgoire, a certified financial planner in Bethesda, Md. "They're structured around the index approach and they have an up-to-the-minute valuation."
Basically, ETFs are a twist on the plain old index fund. Like index funds, ETFs offer a cheap and simple way to invest across a broad spectrum of the United States stock market. Most ETFs track one specific index. Others allow you to invest by industry sector, size, region, or investment style. But ETFs offer three key advantages over mutual funds:
• Unlike mutual funds, prices of ETFs fluctuate during the trading day. Their net asset value is determined by adding up the value of all the fund's holdings and dividing by the number of outstanding shares. By contrast, mutual funds are priced according to their net asset value at a particular point in time, usually 4 p.m. in New York. Because ETFs are traded like a stock, they cannot be manipulated by so-called "market timing" - the use of quick trades at the end of the trading day that skim profits from mutual-fund shareholders. (This practice has been under investigation by regulators in recent months.)
• They're more tax efficient - you aren't as likely to get hit with a taxable capital-gains distribution as you may with ordinary mutual funds. Since ETFs represent indexes, which generally have low turnover, most capital gains occur when you sell shares. Just remember, you'll pay a broker's commission every time you buy or sell shares.
• Since ETFs track indexes, they have lower fees than most funds. And, if you want, you can buy just one share of an ETF, in most cases for less than $100. Minimum initial investments for mutual funds average about $2,000.
"I'm recommending ETFs to my clients right now," says Richard Smith, a certified financial planner in Annandale, Va. "They're cheaper to trade, there's the liquidity factor, you're not buying any one mutual fund, and, perhaps most important to our clients - there's no conflict of interest."
ETFs have boomed in recent years. There are now 116 ETFs compared with 80 in 2000, according to the Investment Company Institute. Total assets have grown to $128.9 billion through the end of October. That's peanuts - less than 2 percent of the $7.2 trillion invested in mutual funds - but it represents a near doubling of ETF assets since the end of 2000. Investors poured $1.2 billion into ETFs the week ended Nov. 7, the most this year.
Most ETF assets have flowed into a handful of funds that track broad stock indexes. They include the Nasdaq 100 Index Tracking Stock, known by its ticker symbol, QQQ; the Diamonds Trust, made up of the 30 firms in the Dow Jones Industrial Average; and the Spider, or Standard & Poor's Depositary Receipts, which tracks the S&P 500 stock index.
The largest family of ETFs is iShares, offered by Barclays Global Investors. You can invest in ETFs in your 401(k) retirement plan only if your company allows you to buy through a brokerage. (Remember ETFs are like stocks in this regard.) Generally, few 401(k) plans offer access to ETFs, says Chris Traulsen, a senior fund analyst with Morningstar in Chicago.
Mr. Traulsen also warns that ETFs may not be suitable for investors who like to trade often. "Unlike a 401(k) - where you just pay an annual fee - with ETFs you'll have to pay a brokerage commission every time you make a transaction.... These costs can add up significantly if you plan on buying and selling ETFs regularly."
Traulsen adds that people who make regular investments through a trading technique known as dollar-cost averaging may be better served with no-load index funds because their shares can be bought without paying brokerage commissions.
Another disadvantage is that since ETFs have no fund manager making investment decisions, buying and selling rests solely on the investor. ETFs may also not be suitable for investors hoping to outperform a stock or bond index because ETFs simply track indexes; they do not beat them.