From the April 2008 issue of Research Magazine • Subscribe!

Learning the ABCs of ETFs

Few could have predicted that the rise of exchange-traded funds as mainstream investment products would happen so swiftly. As index funds that trade like stocks, they are elegantly designed for both broad and narrow asset class exposure. Furthermore, they offer all of this at a reasonable cost and with maximum tax-efficiency. Is it any surprise that ETF assets are destined to soon reach $1 trillion? Simply put, ETFs have made the world a better place to invest.

In some ways the growth pattern of ETFs has resembled that of their mutual-fund cousins.

The precursor to today's mutual fund was the Alexander Fund. It was launched in Philadelphia in 1907 and it laid the groundwork for creating and redeeming fund shares at net asset value. Later on, in 1924, the Massachusetts Investors Trust (MIT) was introduced with the first modern open-end structure. After one year it had 200 shareholders and $392,000 in assets. Three decades later, there were 155 mutual funds with over $15 billion in assets. By the end of 2007, there were over 8,000 mutual funds with assets just over $12 trillion.

When the first U.S.-listed ETF was launched in 1993 by State Street Global Advisors, the world hardly noticed. Seven years later, the number of funds was still under 100, but ETF assets were on the verge of cracking the $50 billion mark. By comparison, mutual fund assets didn't reach the $50 billion threshold until the end of the 1960s. What took mutual funds 45 years to accomplish, ETFs had already done in less than a decade. What led to the remarkable growth of ETFs?

"Stockbrokers needed a way to invest their clients' money in index funds because during the late 1990s, their clients were transferring billions of dollars out of their firms to a low cost Vanguard 500 fund," explains author Richard A. Ferri, CFA. The SPDRs S&P 500 (SPY) offered an attractive alternative to traditional index mutual funds and as more people started understanding this, assets began to grow. As a result, ETFs began to fill a void in the brokerage industry. Today, the SPDRs have amassed more than $80 billion.

Evolving ETFsThe evolution of ETFs has also expanded the number of investment opportunities.

Hedging strategies to reduce risk is a useful technique for employees who are paid with restricted securities or company stock. For example, a person working at Dell Computer could easily diversify some of their corporate stock with a corresponding technology ETF.

What about cumbersome asset classes? The introduction of currency-linked ETFs and exchange-traded notes (ETNs) has made it convenient and economical to trade and own currencies. Making a road trip to your local bank to swap foreign currency is no longer the only choice.

Likewise, the securitization of commodities through ETFs has added a new dimension of opportunity. Instead of buying, storing and insuring physical commodities, investors have a viable alternative with commodity-linked funds. From the strict viewpoint of diversification, commodities may be a good idea, but Ferri cautions, "Over the long run, an investment in physical commodities and individual commodity futures has returned about the Treasury bill rate before taxes and expenses."

Index ProliferationInterestingly, Ferri reveals a subtle reason behind the boom in ETF investments: the proliferation of indexes based on investment strategies rather than market benchmarks.

The Securities and Exchange Commission had a mandate that all ETFs follow an index, but it didn't clarify what an index was. He explains, "Many active strategies were reshaped into rules-based 'strategy indexes' for the sake of launching new ETFs."

The first generation of ETFs intended to capture the performance of plain vanilla market-capitalized indexes. That began to change in 2003 after PowerShares introduced its first two funds. Instead of following traditionally constructed stock indexes, the PowerShares Dynamic OTC Portfolio (PWO) and the PowerShares Dynamic Portfolio (PW) followed an alternative strategy of selecting stocks by using quantitative screens and assigning each holding an equal weighting. These nontraditional methods for index assemblage opened up new possibilities and a flood of ETF products followed.

Given the growing number of ETFs, a conundrum now facing many financial advisors is how to build rock-solid ETF portfolios for their clients.

A helpful suggestion mentioned in the book is to first categorize investors into the following four "life phases:" Early savers, mid-life accumulators, new retirees and mature retirees. Since each category has a different time horizon and contrasting investment objectives, shouldn't their ETF investments reflect that? Each group is then assigned a model asset allocation of funds, which can be adjusted over time to meet the unique financial needs of the individual. This is an excellent approach for advisors looking to make the most of their business.

One last tip relates to the timing of ETF trades. Implementing trade orders during the day when an ETF's market price is trading closest to its intraday value is the most ideal time for order placement and execution. As such, the author suggests not trading ETFs until after 10 a.m. (EST), when the intraday value and ETF market price are likely to match.

Few individuals are more qualified than Ferri -- a practitioner rendering financial advice and managing north of $1 billion in client assets -- to explain the history and the future of ETFs. His writing style is detailed and methodical, but not to the degree where a reader might get bored or lose interest. Whether you're a first-timer or an experienced user of ETFs, you'll benefit from his insight by reading this book.

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

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