Vol 8 No. 5 - Octobe 24, 2007

Exchange traded funds come of age

By Tom Breiter
sun contributor

The most significant trend in the investment industry over the last several years has been the explosion in the number of exchange traded funds (ETFs) available. I have touched on this concept in past articles, but thought it would be a good time to review this investment vehicle again to clear up some misconceptions we have noticed in talking with individual investors.

Some of the shenanigans which took place in the traditional mutual fund industry back 5 or 6 years ago caused some investors to look for alternative investment vehicles, and the evolution of computer-based trading has made ETF’s economically feasible for the underwriting company.

ETFs are mutual funds, but instead of sending money to the fund company and having it create shares in your name, you would make the purchase of the shares on a stock exchange, as indicated by the name of these funds. Obviously, this process requires a brokerage account where stock exchange transactions can be processed, and regular transaction fees will apply on the purchase or sale of ETF shares based on the commission rates of the firm where you hold your account.

The most important item to be aware of is that, at the present time, ETFs are all indexed funds. This means that the stocks or bonds owned inside the ETF are held in the same proportions as those securities represent in the index that the fund is designed to mimic. For example, the ETF known as the Diamonds Trust (symbol – DIA) is modeled after the Dow Jones Industrial Average and will hold the 30 companies that make up the Dow Index in the same proportion that they represent within the index.

There are several significant advantages of ETFs, but I wouldn’t just make a blanket decision to use ETFs and never use traditional mutual funds again. There are some times that an actively managed, non-indexed fund can provide better return and risk characteristics, and your portfolio can be enhanced by the use of both of these types of funds.

ETFs tend to have lower internal expense ratios than actively managed funds. These expenses typically range from 0.1 to 0.6 percent for ETFs while actively managed funds tend to run in the 0.75 to 1.5 percent range for annual operating expenses. ETFs have lower expense ratios primarily because they do not require a research team and a very skilled fund manager to select investments. Rather, they simply own the same securities in the same proportion as the index they are designed to mimic. Of course, there are a lot of indexes to be followed, and it seems that new ones are being created each day, just to allow for a new ETF to be designed.

The most common indexes are, of course, the Dow Industrials, S&P 500, NASDAQ, but you can also find ETFs that target specific market sectors like energy, technology, and healthcare. There are also ETFs which invest in companies that have certain characteristics, such as dividend payment history or environmentally friendly business practices or even companies which reside in a particular country.

ETFs also tend to be very tax efficient. Since they mimic an index, they have lower turnover and generate very little or no capital gain distributions to shareholders. This makes them particularly suitable for non-tax qualified brokerage accounts for investors who are in a high tax bracket.

I mentioned earlier that there are times when we believe that actively managed funds are still an advantage to investors, despite the fact they carry higher expenses and may not be quite as tax efficient.

Our research has revealed that in certain areas of the market, active management can add enough additional return to overcome the additional expenses inherent in the traditional mutual fund structure. Active management may also provide a more risk-averse approach, which for conservative investors is worth the slight extra cost.

In particular, we favor active management for investing in areas like international stock markets, and smaller companies here in the US. In the fixed income arena, we believe that active management can provide advantages in the high yield corporate bond segment.

In summary, I would learn more about ETF’s by visiting the websites for iShares, PowerShares, and WisdomTree. Just do a standard web search for these. There are also ETF’s offered by Vanguard and Fidelity, which of course are the very large traditional mutual fund companies.

Tom Breiter is President of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.

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