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ETFs make a splash
But educate yourself before diving in
By James Guilfoil, CFP®
July 2007
The explosive growth of exchange-traded funds may tempt investors to brave this new category, but buyers should educate themselves before jumping into the ETF pool.
From what began as a single product in 1993, when State Street Global Advisors introduced the first ETF based on the S&P 500 Index, ETFs have taken off like a rocket the past few years. There are now more than 500 ETF products trading in the United States, with assets totaling more than $485 billion. Since January, investment firms have launched more than 100 new ETFs.
ETFs may provide low cost, transparency and tax efficiency.
The concept and appeal of an ETF is simple. They represent the market. They won't have a chance to outperform the market, but they will at least get a return very close to what the market returns.
ETFs are baskets of stocks or bonds whose performance is tied to an index that reflects a particular market segment. Unlike mutual funds, which are priced just once a day after the market closes, ETFs can be traded throughout the day with fluctuating pricing, like a stock. As an index-based fund, the investment objective of an ETF is to match the performance of the index it is tied to, minus expenses.
So, for example, iShares Russell 2000 Index Fund, managed by Barclay's Global Investors, attempts to match the performance of the small-cap Russell 2000® Index. Russell Investment Group does not manage or offer ETFs, or provide advice about purchasing them, but 32 ETF products are based on Russell's family of global indexes.
The first ETFs grabbed the best-known indexes - Russell, S&P, Nasdaq, MSCI. These indexes represent mostly core asset classes: large cap, small cap, international, etc. As a result, the 10 largest funds make up nearly 45% of the ETF market. To satisfy investors' apparently insatiable appetite for more ETF products, firms are now creating niche ETFs based on thinner slices of the market, such as commodities, water discovery and foreign markets. The 100 smallest ETFs average just $10 million in assets with a combined 0.2% market share.
With the increased number of niche products, there is growing concern whether the more marginal players and funds entering the ETF marketplace have staying power. Investors should evaluate the risk of such products.
Low fees but brokerage commissions apply
One of the attractions of ETFs is their low cost, but there is variation among funds. Based on Morningstar data, the percentage of fund assets deducted each year to cover management fees and other costs can range from a low of .07% for Vanguard's Total Stock Market ETF to .85% for the iShares MSCI Taiwan Index. Some index-based mutual funds have similarly low expense ratios.
ETFs are fairly cheap if purchased with a straightforward trading commission, sometimes less than $10 a trade through a broker. The lure of low cost can get eaten up by these trading costs.
Transparent holdings, more tax controls
Transparency is another benefit to take into consideration. With ETFs, what you see is what you get. Each fund contains a basket of securities that is clearly defined and changes only when the fund's underlying index does. Russell indexes, for example, are reconstituted annually with the changes communicated over a month-long process.
Finally, because ETFs trade like a stock, they can offer tax advantages when compared to most mutual funds. Just like an individual stock, ETFs are bought and sold on an exchange. In contrast, mutual fund shares are bought and redeemed directly from the fund company. With ETFs, you avoid potential tax consequences of other shareholder activity. You own your trades and the resulting tax implications. Additionally, since ETFs are constructed to tightly track an index, they tend to have lower portfolio turnover and therefore are less likely to realize capital gains than heavily traded active funds.
With low costs, transparency and apparent tax efficiencies, ETFs have been a great addition to the investment landscape. However, given the myriad competing choices, it makes even more sense to consult with your financial advisor before jumping into the ETF pool.
Copyright© Russell Investment Group 2007. All rights reserved.
ETFs, like any investment, have risks. You should carefully consider these risks before investing. This information does not constitute nor should it be construed as investment advice. You should consult your own financial advisor with respect to your own situation or that of any entity which you represent or advise.
S&P 500 Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the U.S. large cap securities market (representative sample of leading companies in leading industries).
Russell 2000® Index: Measures the performance of the 2,000 smallest companies in the Russell 3000® Index, representative of the U.S. small capitalization securities market.
Russell Investment Group is the owner of the trademarks, service marks and copyrights related to its respective indexes.
First use: July 2007
RC 4719
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