Popular ETFs may offer advantages over mutual funds

August 1, 2004

Q My broker has recommended that I purchase exchange-traded funds, and in particular, an "SPDR." Are these investments as good as they seem?

A. As their name implies, exchange-traded funds (ETFs) are baskets of securities traded, like individual stocks, on an exchange such as the American or New York Stock Exchange. Unlike regular open-end mutual funds that are priced once a day at the market close based on the value of the underlying holdings, ETFs can be bought and sold throughout the trading day at the current market price.

In addition, because ETFs trade like any other common stock, they can be bought on margin, allowing you to borrow funds and leverage your investment. Margin buying can prove very beneficial if the security price is rising, and it can be quite disadvantageous if the price of the security goes down, thus necessitating a "margin call" from the broker. If, on the other hand, you do anticipate a falling security price, you can "sell short" (selling first, then buying back the shares in the future) your ETF shares, which is not possible with a regular mutual fund.

The popularity of ETFs has increased quite dramatically since their introduction in 1993. Based on data from the Investment Company Institute, the ETF industry has grown from just one offering in 1993 and $464 million in assets to 134 ETF choices representing combined assets of $162 billion. While much of the growth has been attributed to institutional investors, individuals have also greatly participated in ETFs' expanding appeal.

For the individual investor, the advantage of ETFs over mutual funds centers around two issues: lower annual expense ratios and tax efficiency. With open-end mutual funds, regardless of whether they are purchased on a "load" or "no-load" basis, internal fund expenses are absorbed by the shareholder. However, investors must keep in mind that, while ETFs have lower internal expenses, the investor must pay a brokerage commission for each transaction, just like with any common stock. If you are going to invest on a regular basis, as many mutual fund shareholders do, commission costs over time can negatively impact performance.

Tax efficiency is provided through the index focus of ETFs. Since they are not "actively managed," securities are only bought or sold based on changes in the underlying index being replicated, which is the same as with passively managed index mutual funds. Index funds in general, whether purchased via an ETF or a mutual fund, are more tax efficient than mutual funds in which the manager makes many changes in the portfolio, causing an income tax liability to be passed through to the shareholders.

While ETFs can provide certain advantages, it is important to keep in mind that unlike regular mutual funds, ETFs' pricing in the market is subject to supply and demand of the issued shares. While the price of the ETF is closely tied to the value of the underlying index securities, prices may be at a premium or a discount to the actual net asset value of the portfolio. This differs from regular open-end mutual funds where the daily price is exactly that of the underlying assets. While ETFs have gained in popularity over the last 10 years, they are not for everyone and remain best suited for investors who would like to invest in index funds but want the same trading scenario as for common stocks.

Q With interest rates trending higher, does it still make sense to refinance my mortgage?

A. Changes in the interest rate environment are inevitable. Inflationary concerns cause rates to increase, while poor economic data keeps pressure on lower rates.