From the February 2007 issue of Boomer Market Advisor • Subscribe!

February 1, 2007

Peace within the portfolio

Described as precision-guided investments by one expert, exchange-traded fund inflow rates continue their stratospheric rise. Combined domestic ETF assets reached $383.3 billion in the latest ICI compilation. Assets of all exchange traded funds rose by $32.98 billion in October, or 9.4 percent. Over the past 12 months, ETF assets increased $119.47 billion, or 45.3 percent.

Although ETFs have received a good deal of attention lately, they have a long way to go to match their older and more established counterpart -- mutual funds. A rebounding economy caused the investment mainstay to pass the $10 trillion mark, and ICI reports that inflow rates doubled across almost all product lines between September and October of last year.

A strong case can be made for holding both within the boomer portfolio, and a number of companies, including Boston-based State Street Global Advisors and Chicago-based Nuveen Investments, are educating their advisors on the differences and similarities between the two products.

Like mutual funds, ETFs offer retail and institutional investors the opportunity to invest in a diversified basket of securities. Unlike mutual funds, ETFs can trade throughout the day and employ stock-like trading strategies, including limit, stop, and market orders, as well as short sales. In some cases, they also can be bought on margin.

Sonya Morris, editor of Morningstar ETF Investor, says ETFs receive some of the spotlight cast on the industry segment they track.

"ETFs themselves have been getting a lot of press," Morris says. "But the ones that get the most press are [those] that focus on the eye-popping industry of the day. Commodities have gotten a lot of attention this year."

"There are a lot of innovations in the market and a lot of new ones coming out," adds Anne Kritzmire, managing director of closed-end funds and structured products with Nuveen Investments. "People want more ways to slice and dice the market and want to use new and narrowly focused ETFs to give them exposure to different sections of the market."

To be sure, ETFs present some enticing features when compared to standard mutual funds -- chief among them a lower expense ratio.

"That can make [ETFs] particularly attractive in emerging markets," Morris says, "where traditional mutual funds tend to run on the pricey side."

As a rule, ETFs generally are more tax efficient than traditional mutual funds and then, as mentioned, they offer trading flexibility for those few investors who may be looking to short their investments, to hedge one way or another, or to pursue a more agile approach to asset building.

But similar to a stock investor who constantly churns, impatient ETF investors will pay a price. Since ETFs trade like stocks (with commensurate brokerage commissions), investors are charged every time a transaction is made.

"If you're trading them with frequency," Morris says, "the brokerage fees can quickly erode the benefit of the low expense ratios."

Also, with index ETFs, the product is little more than a simple index fund that tracks pre-set benchmarks in a given sector. "If investors are interested in having active human management," Kritzmire says, "they might not be interested in a passive index fund." Particularly for the boomer investor, closed-end ETFs can offer intriguing benefits. Nuveen, which deals exclusively in closed-end products, has developed a number of products that offer monthly cash flow.

"The boomer wave is driving a need for active cash flow, and you'll see strategies that have a few 'moving parts' that generate cash flow no matter what broader trends are happening," Kritzmire says. "People are [also] looking for interesting ways to harvest dividends. Closed end funds -- because they don't have money going in and out -- can really can stick to a single strategy and use asset classes that might otherwise not be highly liquid."

As a result, an investor can benefit from exposure to those asset classes without having to tie up liquidity. "You've got a professional manager taking advantage of that liquidity," she concludes, "and producing monthly cash dividends."

Given that both products have attractive and distinct qualities, both Morris and Kritzmire agree that mutual funds and ETFs can -- and should -- co-exist.

"It's definitely not an either/or scenario," Morris says. "Both advisors and do-it-yourselfers can use ETFs and mutual funds to construct sturdy, efficient portfolios." For boomer advisors not as well-versed in ETFs as they are in mutual funds, Morris offers the following advice.

"Concentrate on the long term, don't get caught up in the 'latest sector,' construct a diversified, straightforward portfolio of ETFs and keep trading to a minimum."

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