Exchange traded funds growing in popularity

Wednesday, December 29, 2004 at 1:00am

If you are not totally happy with your mutual funds or stock portfolio, there is another product on the market that might give you financial performance. Exchange-traded funds or ETFs, first created in 1993, may offer superior performance along with some advantages you never though possible.

They take the form of hybrid securities that have the characteristics of stocks and mutual funds, while combining the advantages of both into one product.

Like a stock, an ETF is traded on exchanges so investors can buy or sell shares at anytime during the trading day. But they are set up more like a traditional index mutual fund, having dozens or more similar securities grouped into one package.

"One of the great things about ETFs is they reduce risk by spreading it out among many securities," said J. D. Steinhilber, owner and founder of AgileInvesting, a subscription service and advisory firm headquartered in Nashville that offers investors recommendations on ETF portfolios.

As an example, investors interested in technology related stocks but afraid of concentrating in any one stock or a few, can invest in the NASDAQ 100 Index Tracking Stock ETF. It is one of the most popular securities of this type.

"They are one of the most attractive products to come down from Wall Street in some time," said Bruce Bittles of Nashville, chief investment strategist for the stock brokerage firm Robert W. Baird and Co.

ETFs have primarily been used by institutional investors and experienced traders; however, this is changing.

"They allow the average investor to develop a portfolio like the pros prefer to use," Bittles said.

The research firm Greenwich Associates has reported 75 percent of all hedge funds, half of all financial advisers and a third of pension funds already use them.

According to Steinhilber, the average buy-and-hold investor has rapidly begun to warm up to the new investment product category, which now has assets of over $200 billion. They still have a lot of growth potential in the $7.5 trillion fund market.

ETFs are very cost effective for an investor who wants to purchase and leave the money there for awhile.

Fees for the product are typically considerably less than for actively managed mutual funds, costing about 0.25 percent as an average expense ratio compared to 1.25 percent, respectively. They also have slightly lower fees than index mutual funds.

However, because they are traded like a stock if the investor wants to trade a lot, commission broker fees must be considered as an additional expense. Of course, discount brokers can be used for the transactions.

A big plus for ETFs is the tax advantage. Unlike a mutual fund where every stock turned over within a fund is subject to taxes for the investor owner, this hybrid requires taxes be paid only once. Taxes are due on profit made when an individual ETF is sold, just like with traditional stock transactions. The result is that an individual investor is given control over his or her tax situation.

Steinhilber said ETFs offer a hidden advantage to portfolios some investors may not notice at first.

"Most portfolios are put together haphazardly and don't offer real asset allocation benefits with investors ending up with a patchwork structure," Steinhilber said. "The use of ETF's allow an investor to more easily asset construct more diverse portfolios."

Steinhilber added that his approach is to expose investors to a broad range of uncorrelated asset classes.

He said his role as an advisor is to help his clients with asset allocation by making sure they stay disciplined, stick to their plan, not let emotions hurt performance and avoid overvalued asset classes.

ETFs are now available in about every category - domestic stocks, international stocks, bonds and even some commodities such as gold.

Because of their growing popularity, even mutual fund groups are beginning to offer them. Vanguard, the well know index fund family, offers several.

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