Clients who want or need to increase their equity exposure these days may be unwilling or unable to follow the traditional paths. Some will resist committing to mutual funds, with the industry still reforming its way out of recent transgressions. Others may not be able to achieve adequate diversification or customized sector exposure in a portfolio of individual stocks. Exchange-traded funds (ETFs), which combine some of the benefits of both mutual funds and stocks while removing certain drawbacks, offer an attractive third alternative.

ETFs are among the fastest-growing sectors of the capital markets. Created just 10 years ago, there are now more than 100 ETFs listed on the American Stock Exchange. Assets committed to these instruments, which today exceed $150 billion, are forecast to reach upward of $500 billion by the year 2007, according to The Financial Research Corporation.

While ETFs initially gained favor among institutional investors who use them in sophisticated hedging strategies, their applications for individual portfolios are becoming increasingly popular. In December 2003, investors poured a record $12.57 billion into ETFs, according to the Investment Company Institute. Analysts attributed the sharp rise to higher equity markets and the inclination of some investors to avoid mutual funds in the face of the industry scandals over market timing and late trading.

ETFs combine the mutual fund benefits of affordable diversification with the convenience and transparency of an exchange-traded share. Each share of an ETF represents an interest in a basket of stocks constructed to replicate a large market index such as the S&P 500, a “style” index such as the Russell 2000 Value, a sector index such as the S&P Utilities Index, or a bond index such as the Lehman Aggregate. International ETFs may be based on a broad regional index or a specific country. Whatever your client’s asset allocation or risk appetite, chances are there’s an index and corresponding ETF to match.

ETF shares are bought and sold on an exchange–the American Stock Exchange is the clear leader with the most ETF listings–and priced throughout the day. Their performance tracks the index they replicate, before expenses, typically with minimal tracking error. The cost of buying and selling the shares depends on your arrangement with your custodian or broker/dealer.

Core or Explore

Within a client portfolio, ETFs can play a variety of roles. A broad-market ETF can serve as the core equity holding. Even if you prefer actively managed instruments, in the large-cap space particularly it is very difficult for managers to outperform broad index benchmarks significantly or consistently. With a client’s core allocation invested in a broad-market ETF, the smaller and more specialized allocations–small cap or international, for example–can be invested in actively managed funds or in the ETF that corresponds appropriately to the need.

Another option is to use a combination of sector ETFs to construct a portfolio that overweights certain sectors and underweights others to reflect the client’s investing profile and risk tolerance. Conservative, income-oriented investors could allocate more to energy and utility sector ETFs, for example, while more aggressive investors with longer time horizons might emphasize technology and financial sector ETFs.

Table 1 provides examples of how to allocate this way.

To see how the allocation might work when international stocks, bonds, and cash equivalents are added to the overall asset allocation, see Table 2.

From another perspective, a sector or style ETF can also be used as an “explore” tool to complement core holdings in the form of a stock portfolio or mutual fund and as a means of increasing the client’s exposure to a particular sector or style in a manner consistent with his or her goals.

However you choose to use them, ETFs give you the flexibility to accommodate preferences specific to your client. Perhaps you’re working with a technophile who wants to take a personally active approach to the technology sector. You can use individual stocks for that portion of the allocation and round out the portfolio with the eight other sector ETFs that will effectively cushion the technology risk with broader diversification.

For another example, consider a prospect who currently owns a collection of stocks, as well as index and actively managed funds. In reviewing the portfolio, you realize there is an overexposure to certain sectors because the individual stocks are also owned by the funds. Meanwhile, the client is missing exposure to other key sectors. To correct the imbalance, you can recommend replacing a portion of the overexposed sectors with sector ETFs from the underweighted sectors and add greater diversification to the overall portfolio.

Like Mutual Funds…but Different

ETFs share the built-in and affordable diversification that conventional mutual funds offer, with some added advantages associated with common stock: ETF shares can be sold short on a downtick or uptick, purchased on margin, and traded through stop and limit orders that enable clients to add more control over risk. Dividends paid on the underlying shares are passed through to investors. Options are also available on most ETFs, creating the possibility for a variety of portfolio hedging strategies. ETFs are subject to the same risks as stocks, too, including those related to short selling and margin account maintenance.ETFs also offer transparency in both pricing and portfolio holdings, the possibility of lower expense ratios, and tax efficiencies. In contrast to most funds, which are priced once daily at 4 P.M. Eastern time, ETFs trade throughout the day and their net asset values are updated about every 15 seconds. This not only makes their prices completely transparent all day, it also makes them invulnerable to the market timing and late-day trading that have recently tainted conventional mutual funds. ETF holdings are as transparent as their prices, because they mirror the stocks in the underlying index. If the index changes, the ETF adjusts, so there’s no risk of “style drift,” either.

ETF expense ratios are relatively low. Morgan Stanley Research published a report on January 6, 2004 that found that the average expense ratio for a domestic equity ETF is 0.29% (29 basis points), compared to an average of 1.52% (152 basis points) for all actively managed U.S. equity funds. In international funds, the average expense ratio for an ETF is 66 basis points, while the average for conventional mutual funds is 189 basis points. Purchases and sales of ETF shares are subject to brokerage commissions, however, which will vary with the type of broker used. ETFs have no minimum investment, and the exact number of shares needed by an investor can be bought or sold, usually without incurring premium commissions for odd-lot trades.

One of the biggest advantages of ETFs is their tax efficiency. Capital gains distributions are rare occurrences for ETFs since ETFs are index funds, meaning portfolio turnover is relatively low and trades occur within the portfolio only when the composition of the benchmark index changes. ETF portfolio managers also do not have to liquidate positions to raise cash when shareholders are selling. When institutions want to unwind large ETF positions, the portfolio manager gives them proportional shares of the underlying securities. This principal transaction qualifies as an in-kind distribution, which is not subject to capital gains tax and does not trigger a capital gain for other investors in the fund.

In terms of capital gains distributions, the track record of ETFs is better than even the track record of conventional index funds. The 10-year average annual capital gain for an S&P 500 ETF is 0.01%, compared to 1.87% for the average open-ended S&P 500 Index fund, according to a January 2004 report from Morgan Stanley Research.

In most cases, the only time an ETF investor is going to face a significant taxable gain is when the shares are sold in the secondary market.

Advisors’ Value

ETFs offer advisors a convenient vehicle for demonstrating the value added by professional advice. When your portfolio analysis shows a client’s other holdings create an overexposure to a particular sector or stock, ETFs can immediately and efficiently adjust the balance. With ETF offerings available to slice and dice the bond and stock markets in virtually every conceivable way, they can be a means to rebalancing any time an asset allocation veers off track. When the portfolio of a client who wants to be fully invested happens to generate cash from profit-taking or new cash inflows, the liquidity of ETFs also makes them suitable for short-term investments.

At year end, as you analyze your clients’ tax situations and go tax-loss harvesting, ETFs can come in quite handy. When a particular mutual fund or ETF is down for the year but you still want to maintain market exposure, you can sell the current holding, move the funds into another ETF for at least 31 days, and then move them back to the original holding if you wish. ETFs are not all created equally in terms of expense ratios, which may be a reason to return to the original investment.

In short, ETFs offer just as many opportunities for individual investors as they do for institutions. If you have not yet explored their possibilities, you owe it to yourself–and your clients–to do so.

Daniel P. Dolan is Director, Wealth Management Strategies of Select Sector SPDR Trust, a family of exchange-traded funds (ETFs) that divide the S&P 500 into nine individual sector index funds. He can be reached at dan.dolan@spdrindex.com.