Published August 14, 2001

ETFs and Mutual Funds

Are they Soul Mates?
In 1996 and 1997, index funds, with their low expense ratios and diverse nature were the toast of the mutual fund world, destined (as many pundits thought) to put traditional funds out of business. Today, exchange-traded funds (ETFs) are being touted as the next big thing and are giving index funds a run for their money. Plucked from relative obscurity, ETFs, which were created about seven years ago, have found their way into the minds and pocketbooks of today's investor. Often described as a hybrid between an index mutual fund and a stock, this class of funds tracks a particular index or basket of stocks, but trades like a stock—including brokerage commissions for their purchase and sale. ETFs can be bought and sold throughout the day and can also be sold short or purchased on margin. Basically, ETFs trade between investors, while traditional open-end mutual fund transactions take place between the investor and the fund company, which must stand ready to buy and sell shares at all times—even if this results in the need to sell fund holdings to meet shareholder redemptions. The ETF market has ballooned in the past five years, growing from around $1 billion in assets in 1996 to more than $50 billion today. Since the end of 1999, the number of ETF funds available has risen by 160%. Two-thirds of the ETF market is concentrated in QQQ (called Qubes), which mirror the technology-laden NASDAQ-100 Index, and SPDRs (said Spiders), which track a variety of Standard & Poor's indexes.

Despite their rapid growth and seemingly ubiquitous presence, however, the average investor hasn't dabbled in the ETF universe. According to Financial Research Corp., eight out of 10 investors are not even familiar with the words, 'exchange-traded funds.' Rather, ETFs' primary shareholders are institutional investors, including investment advisors. More and more, ETFs are finding themselves in the portfolios of actively managed mutual funds—fund managers are taking advantage of the unique features of this investment tool. For one, their expense structure is relatively low. Compared with index funds, ETFs boast considerably lower fees: an expense ratio of 0.34% per year for the average domestic offering versus 0.50% for the average domestic stock-index fund. Secondly, ETFs may complement a fund's overall tax strategy; because they track relatively static stock indexes or baskets of stocks, turnover and taxable capital-gains distributions are relatively small.

One of the more-compelling reasons for a fund manager to include an ETF in his investment roster, however, is for diversification purposes. An ETF such as QQQ or SPDRs could give a portfolio added, yet diversified, exposure to a particular industry or sector. Without betting on individual stock names, or keeping a large portion of the fund's assets in cash, managers could use ETFs as "placeholders" to maintain diversified exposure to a sector in case there is an interim rally. Further, their highly-liquid nature allows managers to trade them easily, and ride the market's momentum.

In addition, since fund managers buy in large lots and, like stocks, fees are charged for every transaction, it is advantageous for managers to invest in ETFs. In contrast, the small-fry investor (who might wish to incrementally add relatively modest amounts to his account via dollar-cost averaging) would have to pay a brokerage commission every time, thereby allocating a large chunk of his investment toward trading costs.

Although ETFs seem quite advantageous, they have their drawbacks. For one, not all ETFs are as diversified as one may think. Unlike other SPDRs, which track a large basket of stocks, Merrill Lynch HOLDRs tend to focus on specific sectors such as biotechnology, semiconductors, or broadband. In contrast to other ETFs, stocks are never added to Merrill Lynch HOLDRs—when a company goes bankrupt or merges out of existence, it is not replaced. Therefore these portfolios, which start with only 20 names, are very concentrated, and can become even more so over time. Elsewhere, Select Sector SPDRs are considerably top-heavy, with the Tech Sector SPDR concentrating 63% of its assets in its top-10 holdings, with Microsoft alone representing 16%. Moreover, it's not just the obscure ETFs that have this problem; the popular NASDAQ 100 Trust (QQQ) has a whopping 21% of assets in its top-three holdings.

On the tax-efficiency front, although ETFs can offer tax advantages for investors, they are not a tax panacea. ETFs can and do make capital-gains distributions, as those tied to indexes must buy and sell stocks to adjust for changes to their underlying benchmarks. For example, since small-cap companies tend to readily outgrow their indexes, ETFs that track small-cap indexes, experience higher turnover than their average large-cap brethren. Therefore, an ETF such as the iShares Russell 2000 Growth Index probably will not be as tax-efficient as the iShares of the S&P 500 Index. Capital-gains distributions also affect ETFs that mirror foreign-country indexes. Oftentimes an individual holding can make up a significant portion of a foreign index's composition. For diversification purposes, mutual funds and ETFs are required by the SEC to trim back any holding that exceeds 25% of overall assets, thus creating a potential capital gain. For example, the iShares MSCI Canada Index was forced to make a capital-gains distribution because Nortel Networks exceeded the 25% limit and had to be trimmed.

On a more-ideological basis, fund managers who invest in ETFs seem to violate the very reason shareholders invest in and pay for mutual funds: a fund manager's stock-picking expertise. Think about this. Why would a shareholder place his hard-earned dollars in the hands of a manager who invests in what is essentially an index fund. If an investor wishes to add an ETF to his portfolio, he could just buy its shares directly. Another concern for shareholders is that many fund mangers use ETFs as market-timing instruments. This strategy may not coincide with the fund's stated management style. For example, Richard Freeman of Smith Barney Aggressive Growth Fund is a "bottom-up stockpicker who invests in undervalued companies in high growth industries." The fund's 3.35%-of-assets position in the NASDAQ 100 Trust, therefore, does not reflect Freeman's stock-picking investment philosophy—buying the trust is a decidedly top-down approach because it is, essentially, a bet on the entire technology sector and not on individual tech companies.

Although most fund holdings are hand-picked, another fund company, Everest Funds Management of Omaha, Nebraska, has taken the ETF concept to another level. Everest 3 Fund is not an actively managed mutual fund (in a stock-picking sense) but, rather invests exclusively in ETFs. It combines three ETFs: the Qube (QQQ), the Diamond (which tracks the Dow Jones Industrial Average), and the SPDR. For a fee of 0.50% per year, plus the costs of the underlying ETFs, shareholders pay managers Thomas Pflug and Doug Larson not to pick stocks, but, rather, to allocate the fund's assets (on a quarterly basis) among the three ETFs, based on current and near-term market conditions. One of the fund's benefits is that shareholders can invest relatively small amounts without being charged a fee for every transaction. In direct contrast, if an investor placed his money directly into an ETF in small increments, he would have to pay a brokerage commission on every purchase. In order to take advantage of the fund's dollar-cost-averaging feature, however, you must first pony up a minimum of $10,000.

Despite their drawbacks, ETFs can be a powerful investment tool. Their relative cost-effectiveness and tax-efficiency make them attractive and viable options for investors looking for investment vehicles other than index or traditional mutual funds. Whether they belong in mutual funds, however, is another story.

Jessica Paige
Mutual Fund Research
Training Coordinator