- 2000: Volume 9, No. 3 Ask Dr. Index: Are Exchange Traded Funds A High Water Mark?

Investment promoters love to flog their latest offerings as though they were the hottest thing to roll down the pike since Noah showed up to sell condominium interests in the Ark. Does it seem the touts about the new crop of exchange traded index funds are just more examples of such antediluvian hype? And just what ARE these things anyway?

Simply put, exchange traded funds (ETFs) are exactly what the name implies: interests in collective portfolios than can be bought and sold on an exchange much like shares of IBM. ETFs really aren't new—they've been around in a couple of forms for years. Closed-end funds and unit investment trusts were the first generations. The most recent offerings of EFTs, however, are the "open-end" type which offer better index tracking and tax-efficiencies.

ETFs, like stocks, can be bought and sold through virtually any brokerage account whenever the market is open. Traditional mutual funds, in contrast, trade "over-the-counter" at the end-of-day price only.

Exchange trading allows the use of commonly-used stock orders. In addition to market orders, ETFs can be traded with limits and stops. And trade they can. Margin trading, either buying with leverage or short selling, is possible with ETFs. Try doing any of that with a conventional mutual fund.

But ETFs aren't just for trading. They're used for long-term investments, too.

ETFs—at least the current generation—are all index funds. Each tracks a specific market barometer which makes them cost-effective. Because index funds don't actively trade their portfolios, they have modest operating costs. Compared to actively managed funds, index fund portfolios incur lower brokerage commissions, fewer bid-offer spreads, and lessened resulting market impact costs. And since the funds set index replication as an objective, research costs are noticeably lower, too.

Most important, ETFs are tax-efficient. Index portfolio managers typically trade portfolio securities only when the benchmark index's composition changes. That reduces turnover and capital gains tax liability for ETF shareholders. Holders of the newer ETFs are further insulated from capital gains tax liability by the unique structure of the funds.

Conventional mutual fund shareholders purchase and redeem shares directly through their fund's portfolio. In the ETF world, however, individual investors find their trading counterparties through the exchange. It's institutional investors who create and redeem ETF shares. Creation requires the deposit of shares approximating the index composition, plus a cash component, in return for a block of ETF shares. Similarly, block-sized units of ETF shares can be redeemed in return for a portfolio of stocks approximating the index, together with a cash component. Portfolio transactions are thus deemed "in-kind" exchanges. from whence stems the fund's inherent tax-efficiency. The arbitrage opportunity offered by in-kind swaps of portfolio securities also keeps the fund price closely aligned with the underlying index value. If an ETF begins to trade above or below fair value, institutions will move in to take advantage of the arbitrage opportunity—buying or selling stock baskets that make up the index against the ETF upon which it is based—to lock in profits from the price discrepancy.

The resultant small "tracking error" between fund and index values makes ETFs an attractive alternative to index derivatives for asset allocation and hedging strategies. ETFs, in lieu of index futures or index options, can add market exposure to a portfolio or protect assets when a portfolio sale cannot be made. No option or commodity account is needed to use an ETF hedge, but if short selling or leveraged buying is employed, of course, a margin account is required.

Brad Zigler is head of investor education at Barclays Global Investors Services. Questions can be directed to Dr. Index at www.ishares.com/dr_index.