The ABCs of Exchange Traded Funds

Every investor should consider Exchange Traded Funds (ETFs). The younger brother of open-end index mutual funds is growing up fast and showing greater versatility. ETFs are open-end index mutual funds that trade like stocks (and closed-end mutual funds).

There are three legal structures of ETFs: Open-end mutual fund (the difference between the ETF structure and an open-end mutual fund is the ETF is exchange traded, whereas the traditional mutual fund is purchased and redeemed by the fund itself), Unit investment trust and Grantor trust.

The open-end mutual fund structure has a diversification requirement, mandated by the Investment Company Act of 1940, which limit how it mimics some smaller or specialized indices and could result in a tracking error. The other principal difference for the investor is that other than the open-end mutual fund, dividends must be paid out in cash to investors. These structural differences aren't significant for most investors. The more important question is whether it's the right one for you in terms of what index it's designed to follow.

The index and dividend payout requirements are disclosed in its prospectus and most Exchange Traded Funds also have websites where you can find this information. Tracking error is the difference between the return on the index the EFT is designed to follow and the actual return on the index.

An EFT which holds all 500 stocks in the S&P 500, in the same weighting as the S&P 500, should have exactly the same return as that index, less fund expenses. That's an easy one. ETFs that are created to track, say, the biotech stock index will have different interpretations of that index.

A biotech could weight all stocks equally, weight by market cap, hold big cap or small cap bio stocks, and so on. As a result, performance will vary with the success of its strategy. A good illustration of this is in "Biotech ETFs: It Pays to Shop Around", in the October 15th BusinessWeek. The five funds BusineesWeek highlights had year-to-date return ranging from -3.7% to 27.3%.

ETFs are required to disclose their holdings every day, unlike mutual funds which only have to disclose once a quarter. However, this should not be a big deal because we're dealing with index funds and the components of indexes should not change very often.

There are two aspects of ETF liquidity for investors to consider: the ETF and its index's securities. Since ETFs trade like stocks, they can be traded all day long. Open-end mutual funds can be purchased or redeemed only once daily, after the market closes. You have to put your order in prior to 4PM (while the stock market is still open) or wait until the next day. The liquidity of the EFT-the frequency with which it trades and the depth of the market-is similar to a stock and parallels the size of the EFT.

But ETFs also have a very unique feature, they can be expanded or contracted depending upon demand, see Share Creation/Redemption, which provides them with even greater liquidity. And, ETFs can be more liquid than the individual shares they hold, thus, providing investors with greater liquidity. This is especially true for an ETF that holds small cap stocks, which are thinly traded, or bonds other than US Treasuries, which trade infrequently.

Authorized Participants, think big banks who act as market makers or specialists on an exchange, trade market baskets of the underlying index's securities to the EFT in exchange for new ETF shares, when the demand for ETF shares increases. The Authorized Participants then sell these newly created ETF shares on the open market. The process is reversed if there are more sellers than buyers of the ETF.

The purpose of this feature is to keep the ETF's market price as close to its net asset value as possible. (The risk exists that the Authorized Participants would not, or would not be able to, perform this function during a market crisis. The result of this could be an ETF which trades away from its net asset value.)

The price at which the ETF trades is based upon supply and demand. Unlike the share of an open-end mutual fund which is purchased or redeemed at its net asset value (NAV), the price of an ETF share may trade above or below its NAV. By way of comparison, closed-end mutual funds often trade away from their NAV for extended periods of time.

Unfortunately, many closed-end mutual funds trade significantly below their NAVs. The Authorized Participants provide vital role, through share creation and redemption, in keeping the price of the ETF close to its NAV.

The structure of Exchange Traded Funds give the investor a tax advantage over mutual funds. Open-end mutual funds, even index funds, must sell shares of the stock they own to raise cash when redemptions exceed purchases. These sales can result in taxable gains and losses which are passed along to the investor. Thus, you could have a taxable gain on the fund you own, even though you didn't sell it. The share creation and redemption process shifts this liability to the Authorized Participant.

If the Authorized Participant trades shares to the EFT, it is responsible for the taxes on any gains if it sells the securities it received from the ETF. Of course, the investor is liable for any taxes upon selling an ETF or mutual fund.

ETFs have lower fund expenses than index mutual funds, although the difference is usually only a few basis points. (Don't be misled by advertisements which compare their expenses to actively managed open-end mutual funds.) Theoretically, the expenses for an ETF or mutual fund structured to track the same index, assuming they're roughly the same size fund, should be the same.

Since ETFs are traded like stocks, the commission charged to buy or sell is similar to the commission on a stock trade. Index funds are no-load, and are commission free, although some charge a back-end fee if you don't hold it for a certain period of time. The second cost to consider is the bid/ask spread. Even stock and ETF has one, although in most cases they're very small, i.e., a few cents, unless the ETF is very illiquid. Transaction costs-none vs. some-favor no-load mutual funds over ETFs but the cost differential is slight

What are the uses and advantages of ETFs? Come back next week and I'll tell you.