The Lowdown On ETFs

This has been a column for stock-pickers in the New Economy fields of technology, telecommunications, and services. While the market has taken its toll on some of the issues featured over the past year, others have delivered and will likely continue to do so for years to come. Now, I want to expand the New Economy Advisor’s focus beyond single stocks.

Time and again, I’m taken aback by how little some of us know about the most common tools of our trade. If I were asked by my auto mechanic, “Jim, is this a Phillips or a flathead screw?” he wouldn’t be my mechanic for long. But what if a client were to ask you a relatively simple question–like, “When did exchange traded funds come into existence?” Or a more complex one, like “Is the huge daily volume on the Qubes indicative of investor interest or necessary arbitrage?” Can you come up with the answers, not to mention explain how ETFs can be used? If you can’t, you should take Socrates’ counsel–”know thyself”–to heart, and update it. “Know thy instrument” is advice any advisor needs to heed. This is especially true now that ETFs have garnered some $70 billion in assets and on some days rank among the nation’s most actively traded equities.

Most investors, in their bid for better returns, overlook why the particular instrument they’re investing in was constructed in the first place, let alone how it is constructed today. Many advisors do the same. I’m not saying you need to know how to put together a plane in order to fly one. But understanding the structural limitations and possibilities of the plane you’re flying or the instrument you’re buying for a client is a necessary ingredient to happy landings. And in order to benefit from ETFs, which come in many flavors, you definitely have to know how they’re built.

Compared with mutual funds, which date to 1924, ETFs are a much newer form of pooled investment. They are built on the work of Berkeley professor Nils Hakansson, who in 1976 wrote of the possibilities of a SuperFund index which could be broken apart into securities with varying risk and return characteristics. In 1990, Leland, O’Brien, Rubenstein Associates obtained permission from the Securities and Exchange Commission to create a product, called Super- Trust, which made its debut in 1993. This was, in essence, the first ETF. Based on the S&P 500 index, it was traded like a stock, but also offered and redeemed shares like a mutual fund. But SuperTrust was primarily sold as part of a strategy to provide portfolio insurance against market declines, just when demand for hedging instruments was dropping due to their role in magnifying the 1987 market collapse. Also hurting SuperTrust were its complicated structure, limited liquidity, and three-year term. By 1996, SuperTrust was dead.

Still, demand for index investments was growing, with the total of mutual fund and institutional index investments reaching $200 billion by the end of the 1980s. The American Stock Exchange took advantage of the legal groundwork laid by the SuperTrust, and in 1992 received SEC approval to offer Standard & Poor’s Depositary Receipts (SPDRs), an S&P 500 index ETF. “Spiders” were a huge success, and are now second only to the Nasdaq 100 Trust (QQQ, or “Qubes”) in terms of assets and trading volume. Other ETFs track everything from the Dow Jones Industrial Average to mid-cap and Internet stocks.

Since an ETF is a hybrid, partway between an open- and closed-end fund, transactions are usually made between investors via a stockbroker. Unlike mutual funds, ETFs don’t continually buy and sell shares. But a fund may buy and sell large blocks of shares, called creation units, primarily to institutions engaged in arbitrage. This keeps ETF prices from getting far out of line with their net asset value.

Arbitrage Narrows the Spread

ETF net asset values are priced in real time, throughout the day, while mutual fund NAVs are priced once daily, or, in some cases, at hourly intervals. If the market price of an ETF falls below NAV, arbitrageurs can buy a block of ETF shares, sell it to the fund company, and get in return the ETF’s component stocks, plus a small amount of cash, mostly from stock dividends. The arbitrageur can then sell the individual stocks for a profit. If an ETF’s market price exceeds NAV, arbitrageurs can buy a basket of index stocks and sell them to the fund company for newly created ETF shares. Usually the fund company only does this in units of 50,000 shares, but Merrill Lynch’s HOLDRs (for Holding Company Depositary Receipts) do not have this same minimum. All told, ETF prices for the more heavily traded SPDRs, QQQs and DIAMONDS (ETFs on the Dow) are generally within a half-percent of NAV. More specialized and thinly traded products can deviate somewhat more widely.

Although regular stock trading ends each weekday at 4:00 p.m. Eastern time, many ETFs, including most of those based on broad-based indexes and the iShares sector funds, continue to trade until 4:15. So published discrepancies between an ETF’s net asset value, which is set at 4:00, and its market price may reflect that 15-minute discrepancy more than any real deviation between market prices and NAVs. This is even more true for most foreign market ETFs, with Asian markets, in particular, not open when ETFs are being traded.

In addition to their simplicity, ETFs can be sold short. They are also a bargain, with management fees that tend to be lower than actively managed mutual funds and even most index funds. Expense ratios range from as little as 0.09% for the iShares S&P 500 Index and 0.12% for the similar SPDRs, to about 1% for some of the iShares international products, which track Morgan Stanley Capital International global indexes. By contrast, the Vanguard 500 Index mutual fund’s expense ratio is 0.18%. But the fund is bought and sold at NAV, with no brokerage commission. Vanguard 500 Index also levies a fee of $10 per year on accounts under $10,000, and has a $3,000 minimum initial investment. ETFs don’t have such minimums, but even a $15 commission amounts to 1.5% of a $1,000 account.

Thus, an investor starting out with just $3,000 would probably be advised to buy an S&P 500 or total market index mutual fund, rather than one or more ETFs. Index mutual funds may also be a better bet for investors with accounts under $100,000 who use dollar-cost averaging. Even at a bargain-basement broker’s charge of $8 per trade, monthly purchases would mean $96 a year in commissions.

What Am I Bid?

As with stocks, in addition to commissions one may have to “pay” a bid/ask spread when trading ETFs. These spreads vary from zero for SPDRs and QQQs, under normal market conditions, to close to 1% for the least liquid sector offerings and even close to 4% for the most illiquid foreign markets, like the iShares MSCI Brazil index. Note that the round trip bid/ask cost of close to 1% on many sector ETFs is comparable to the 0.75% that Fidelity charges on Select sector funds. But Fidelity only levies its charge on positions sold out within 30 days. Fidelity Select funds also levy a 3% sales load, but that is only charged once if the money is kept within Fidelity. So for rapid sector traders, Fidelity’s Select funds are comparable to sector ETFs, provided the trader doesn’t mind being limited to hourly pricing and doesn’t need unmanaged indexes or multiple Internet sectors. For sector traders who flip positions after a month or two, Select funds would be the cheaper option, while those who are apt to hold on to a sector for the long term will likely prefer ETFs to avoid paying the much higher expense ratios of Select funds.

Using a selected group of ETFs, you can make your own daily map of the market in real time. To do so, I use these ETFs.

To map the indexes that form the overall mosaic of the global market, classified by their construction and by the market cap of the companies they track, I have organized these mainstream indices by market capitalization. Then there are the specialized indexes, some of which track specific industry segments, and some which are idiosyncratic. But they all relate to a better understanding of investing in any ETF.

A Remedy For Clients’ Portfolios?

A low-cost, safer way to invest in biotech is through Merrill Lynch’s Biotech HOLDRS

Many biotechnology stocks have seen a sharp recovery this year after a grim 2000. One low-cost way of investing in biotech is via Merrill Lynch’s Biotech HOLDRS, which trade under the symbol BBH. Like all ETFs, it’s an index portfolio. That doesn’t mean that when the BBH was put together, Merrill didn’t have some leeway in choosing stocks.

But the investment bank’s decisions were quite conservative and in line with indexing principles.