From the June 2009 issue of Research Magazine • Subscribe!

June 1, 2009

Commentary: Why ETFs Are Gaining on Mutual Funds

According to a just released research report from Financial Research Corp. (FRC), an amazing 71 percent of financial professionals used ETFs in 2008, up from just 25 percent in 2003.

How many times have you heard or read it? Exchange-traded funds are overtaking traditional mutual funds in both popularity and asset growth. Regardless of whether you're tired of hearing or reading it, this is a dynamic shift in the nature of the investment management business that financial professionals should not ignore.

According to a just released research report from Financial Research Corp. (FRC), an amazing 71 percent of financial professionals used ETFs in 2008, up from just 25 percent in 2003.

Let's examine four key reasons why ETFs are gaining ground on traditional mutual funds.

Total Transparency

Even though the Securities and Exchange Commission has the noble goal of forcing Wall Street to provide investors with full disclosure, it often misses the mark. A lack of financial transparency contributed to the financial meltdown in certain securities, like credit default swaps along with unregistered hedge funds. Even today, it's difficult to assess the true level of risk taken by market participants if nobody knows who owns what.

What about mutual funds? Funds disclose their portfolio holdings during the first and third quarter using form N-Q and during the second and fourth quarter via the semi-annual and annual report. All holding disclosures are reported with a 60-day lag. Regarding mutual fund holdings, the Schwab Center for Financial Research states, "Frequently, you may not know which securities you're exposed to in the fund or what changes a manager has made until you get the semiannual report."

By contrast, with index ETFs there is always 100 percent transparency about what securities the funds own and holdings can be viewed daily at provider websites.

Intraday Liquidity

Critics of ETFs have tried to demonize their intraday liquidity feature. One argument is that ETFs encourage investors to become day traders. If that's true, what can be said of other exchange-traded securities like stocks and closed-end mutual funds? Shall we take the massive trading volume of Microsoft (MSFT) or Exxon Mobil (XOM) and wrongly conclude that all of the buyers and sellers are short-term traders?

Morningstar recently launched a helpful tool that illustrates the cost of ETF bid/ask spreads in percentage terms. However helpful this new tool is, it's wrong to conclude the cost of bid/ask spreads is exclusive to ETFs.

Other exchange-listed securities, like stocks and closed-end funds have a bid/ask spread cost attached to them too. Also, mutual funds that own stocks are impacted by this subtle cost -- a real cost not reflected in a fund's expense ratio. Wouldn't it be neat if Morningstar could start publishing the full spectrum of mutual fund costs by including bid/ask spread data for the underlying securities on all the mutual funds in its database? It's already done this for ETFs. Why not stocks and mutual funds?

No-Fee Redemptions

Ever since the 2003-2004 mutual fund scandals that involved late-day trading in fund shares and insider market timing, the usage of back-end redemption fees has become widespread. While the main objective of redemption fees is to prevent the rapid-fire trading of mutual fund shares, they've created other unintended problems.

For example, some mutual fund investors are being penalized for selling their mutual fund shares when they rebalance their portfolios quarterly. Even though they're the furthest thing from being day traders, they're being treated the same. In other words, fund investors in some cases are being penalized for doing the right thing! This is a rarely discussed problem that acutely impacts the $3 trillion dollar 401(k) marketplace.

For equity fund investors, redemption fees are everywhere.

For example, Fidelity Select Gold (FSAGX), which invests in gold equities, has a 30-day short term redemption fee of 0.75 percent. The Market Vectors Gold Miners ETF (GDX) has no back-end redemption fee and it charges a lower annual expense ratio. Most of Fidelity's select industry sector funds charge the same back-end redemption fee as the Select Gold fund or a variation of this.

International funds, like the Fidelity Southeast Asia (FSEAX) and the Fidelity Emerging Markets Fund (FEMKX) have 90-day redemption fees of 1.50 percent. The iShares S&P Asia 50 (AIA) and the Vanguard Emerging Markets ETF (VWO), which use similar investment strategies, have no redemption fees.

Greater Flexibility

The fact that ETFs are bought and sold like stocks means greater financial flexibility for all investors. For example, stop orders are designed as an automatic trigger for an order entry or exit once a certain price level has been achieved. ETF stop orders can protect ETF investors by limiting their downside market losses. With mutual funds, it's impossible to know the exact price or net asset value of the fund shares you're buying or selling. Nobody likes to buy products and services at to-be-announced prices; why should they do it with their investments?

Underlying call/put options are another tool ETF investors have that mutual fund investors lack. One commonly used options strategy is to purchase protective put options. This allows an ETF investor to protect long ETF positions and to offset any potential market declines.

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

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