Will ETFs shift into retirement plans?

When Darwin Abrahamson is asked how he'd like to invest his 401(k) plan, his answer inevitably is "in Exchange-traded funds" (ETFs).

That's because Mr. Abrahamson's company, Invest n Retire, has developed technology that adds the investments to 401(k) plans.

"And I think this area is going to absolutely explode," says Abrahamson, whose company, based in Portland, Ore., began offering the service to financial advisers in January.

Though they occupy a small segment of the overall investment universe, ETFs are garnering more attention as investors look for alternatives to traditional mutual funds.

Traded like stocks, ETFs resemble index-tracking mutual funds, but allow investors to buy and sell at will. Unlike traditional mutual funds, which are priced at the end of each trading day, ETFs enable investors to take advantage of quick swings in the market.

Since their creation in the early 1990s, ETFs weren't considered fit for 401(k)s because no one could figure out how to include them, Abrahamson says. But now that more money is flowing into ETFs, Invest n Retire and other companies are clamoring to find new ways to market the product.

And for good reason. Combined assets of ETFs were $238.3 billion in May compared with $166.5 billion in May 2004, according to Investment Company Institute, a national association of US investment companies.

Meanwhile, total assets of domestic-stock ETFs, which include 111 of the 163 total ETFs as of May, increased $16.2 billion to $188.1 billion on a month-to-month basis.

Trading-cost tradeoffs

Baffling some investors is whether they should buy an ETF if they already own the same index-tracking mutual fund. The answer is "no," says Gordon Shuler, an investment adviser at Index Fund Advisors Inc. in Irvine, Calif. "ETFs promote active investing which can lead to high-cost errors."

Others argue that ETFs are cheaper to buy and sell than traditional mutual funds, which often require investors to pay extraneous fees.

"You can have almost an identical portfolio [with ETFs] and cut the cost in half," says Sue Stevens, director of financial planning at Morningstar, an investment consulting company in Chicago.

The lower cost can be explained by comparing the percentage amount a brokerage firm or fund company charges the investor on a per-share basis to manage an ETF versus a comparable index-tracking mutual fund. For example, Vanguard's Total Stock Market VIPERs (ETF) has an expense ratio of 0.07 percent, while Vanguard's Total Stock Market Index Fund has an expense ratio of 0.19 percent.

Expense ratios alone aren't enough incentive to switch to ETFs. Ms. Stevens says some of her more risk-averse clients will prefer ETFs because she can put a stop-loss order on the product if a terrorist attack or some other event sends the market spiraling down.

That also means brokers have to tend to ETFs a lot more regularly than an index-tracking mutual fund. "And because they trade like stocks, there are brokerage fees when buying or selling ETFs," Stevens says.

Investors should also beware of the tax consequences when switching from an index-tracking mutual fund to an ETF. Capital-gains tax could surface if an investor or portfolio manager has to sell holdings to make the switch. One consideration is that an investor with a company like Vanguard may be able to do a "share exchange" without any tax consequences at all, Stevens says.

Beware of the hype

But choosing the right ETF can also be a challenge. The Standard & Poor's Depositary Receipt, which tracks the S&P 500 stock index, is commonly referred to as a "Spider." It has nearly tripled in value since it began trading more than a decade ago on the American Stock Exchange.

As enticing as the returns might be on Spider, investors should take note that it doesn't happen overnight, says Mike Nozzarella, managing director at Tarbox Equity Inc., a wealth management company in Newport, Calif.

Investors should seek out diversity when searching for an ETF, Mr. Nozzarella recommends. Some ETFs contain companies in specific sectors, while others are filled with a variety of different companies in the same asset class.

"Go explore the sectors you're interested in and find the ones with really good asset exposure," says Nozzarella, noting that his firm tracks the S&P 500 using Barclay's iShares.

There are also financial advisers out there looking for something new and fresh to put their clients in. And that's another reason why investors should understand ETFs are far from a-get-rich-quick idea. "There is too much hype out there on ETFs and too many great sales people that are going to make a lot of money doing it," Mr. Shuler says.

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