From the September 2007 issue of Research Magazine • Subscribe!

ETF Fact or Fiction?

In just the last year, the number of exchange-traded funds (ETFs) on the market has shot from 267 to well over 500, with a backlog of ETFs currently at various phases of development. Some have called it a bubble. Iconic figures like John Bogle, Warren Buffett and William Bernstein have expressed their cynicism about ETFs.

Have ETFs become a mania? Do ETFs induce investors to self-destruct? Is there an ETF bubble? Here's a brief sample of the ETF fiction that's floating around:

1. ETFs encourage investors to become hyperactive traders.Intraday liquidity is an important product feature of ETFs. It gives investors a flexible exit strategy by allowing them to buy and sell shares when the financial markets are open for business.

In recent years, trading in ETF shares has exploded and many funds, such as the SPDR Trust (which tracks the S&P 500 under ticker SPY) and PowerShares QQQ Trust (tracks the Nasdaq 100 as QQQQ) dominate the daily volume on major stock exchanges.

However, it's a widely known fact that large institutions -- not individual investors -- account for the bulk of ETF trading volume. It's true that some individuals have become compulsive traders, but the fact is that many were trading stocks in exactly the same way long before ETFs arrived on the investment scene.

After all, individual stocks also have intraday trading just like ETFs. Should we make the case that stocks should be completely avoided because they trade daily and might induce investors to needlessly trade? Making a similar claim against ETFs is irresponsible. Should we fault automobiles for car accidents? How about blaming fire for burning people? Knives for cutting people?

2. ETFs are a bad choice because of the growing number of poor ETF investment options.One gander at the mutual fund marketplace reveals a true lesson in financial clutter. Counting funds with multiple share classes, there are over 20,000 mutual funds to choose from. How about the 9,000 or so hedge funds? Even though the ETF market is headed for the same overcrowded destiny, the clutter is arguably worse elsewhere.

With ETFs, just like with mutual funds, investors need to choose wisely. Favoring funds based upon traditional indexes with rock-bottom costs and a long-term investment horizon never hurt anyone. This is exactly the sort of high value proposition many ETF families offer for anyone smart enough to notice.

3. ETFs are trading vehicles, not long-term investments.Many ETF shareholders own their funds for different reasons. This is considerably different from investing in mutual funds, where individual shareholders typically share the same investment objective. Some ETF investors may have a short-term time horizon whereas others have a longer-term view.

However, even if some investors choose to trade ETFs excessively, this doesn't diminish their appeal for buy-and-hold investors. I believe ETFs best serve investors that are managing serious money, not gambling for short-term profits. Independent studies confirm that traditional index ETFs are just as low-cost and tax-efficient over the long haul as traditional index mutual funds.

4. The ETF industry markets and sells ETFs the wrong way, therefore ETFs are bad investments.It's irrational to judge the investment merit of ETFs by the marketing behavior of fund companies. ETFs should be evaluated by the underlying securities they hold and the investment strategy they follow.

If the ETF industry wants to ape the mutual fund industry by mislabeling funds and launching new products with questionable investment merit, so be it. But broad generalizations and sweeping statements that characterize the entire ETF market as "good" or "bad" are counterproductive.

5. All ETFs are low-cost, tax-efficient and useful.On the other side of the coin, just because something is labeled "ETF" doesn't necessarily make it a good investment. In fact the new generation of "fundamental" or "quantitative" ETFs frequently carry expense ratios double or triple their category average. Isn't this a steep price to pay for new and unproven investment theories, compared to comparable index mutual funds? It's always wise to research the cost of funds tracking the same or similar indexes. In many (but not all) cases, ETFs win. Both Charles Schwab and PowerShares offer funds tracking the same exact FTSE RAFI "fundamentally weighted" indexes, yet Schwab's mutual funds have noticeably lower expenses. (See chart on previous page.)

With regard to utility, it's true that many new ETFs are walking the outer limits of financial usefulness. Faddish funds or those with questionable investment merit probably don't have a place in a serious money account. It behooves informed advisors to separate the good from the bad because your clients are relying on you for direction.

6. ETFs aren't actively managed and this puts investors at a disadvantage. The evidence continues to demonstrate the vast majority of portfolio managers are not adding value, but subtracting it. Seldom-discussed problems such as closet indexing, style drift, excessive portfolio turnover and window dressing plague some of America's largest mutual funds.

In contrast, ETFs protect financial advisors and their clients. Take, for example, portfolio turnover: how long a mutual fund holds the stocks in its portfolio. The typical equity fund averages 100 percent annual turnover. In basic terms, this means the securities in the fund have completely changed in a year's time. Does that sound like long-term investing to you? All of this activity indicates that many funds aren't the long-term investors they purport to be, and academic research reveals that the trading costs that high turnover generates can have a detrimental impact on performance.

The danger of hyperactive portfolio management can largely be avoided by using ETFs. Focus your attention on traditional market-cap weighted funds, such as those offered by Barclays Global Investors, State Street Advisors and Vanguard. The indexes behind many of these funds do an excellent job of keeping portfolio turnover low and minimizing the negative impact of index changes. ETFs with a fundamental or strategy-based slant can also have low relative turnover, but be selective.

FACT AND FICTIONThese six myths represent just the crest of the wave of controversy, debate and criticism that's currently breaking in the ETF marketplace What will you believe? If you're using ETFs to manage your client's portfolios, are you able to defend your investment decisions? Help your clients not to be tricked by the financial fiction that's spreading about ETFs. You're their only hope of getting it right.

If you're among the shrinking number of advisors not yet using ETFs in portfolio management, why? The reasons to start using ETFs are too compelling for you to ignore. Furthermore, you risk losing your competitive advantage by not using world-class financial products just because they're bought and sold in non-traditional ways.

Think about the number of ETF investment strategies at your disposal. There's core/satellite, tax-loss harvesting, sector rotation and hedging, among the more popular strategies. Also, don't forget about the broad asset class exposure into currencies, commodities, real estate and other new areas that ETFs are forging into.

Naturally, all of these financial choices call for diligent evaluation and discriminating selectivity. It's up to educated and trained financial professionals to separate the facts from the fiction. You can do it!

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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