Index funds, shares are similar, but the latter trade like a stock

Your Funds

Dollars & Sense

November 14, 1999|By Charles Jaffe

PAPER OR plastic?

You can debate the differences down to minute details, but both types of bags perform the same job, and the real decision point may be a matter of personal preference.

It's the same with index funds and "index shares."

Index funds, of course, are mutual funds that mimic a specific benchmark, such as the Standard & Poor's 500. They are a low-cost, tax-efficient means of capturing stock market returns.

Index shares, by comparison, act like an index fund but trade like a stock. In truth, they are neither, belonging instead to the investment species known as "derivative securities."

Derivatives sound scary (and in some forms, can be terrifying), hence index shares with some cool nicknames.

Spiders, for example, are Standard & Poor's Depositary Receipts (SPDRs), technically an "exchange-traded unit investment trust." In short, they look like an S&P index fund, smell like an index fund, and perform like an index fund.

But because SPDRs and other index shares are traded on the American Stock Exchange, they trade like a stock, meaning that an investor can sell out at a moment's notice, bailing out of a major downturn immediately, for example, rather than having a sell order processed at the end-of-the-day price of a fund.

Trading like a stock, however, also involves commissions, and those trading costs can swing the cost argument over to funds.

Here's the breakdown on other key factors:

Index shares require larger minimum purchases. Typically, an investor will trade in round lots of 100 shares, which, in some cases, can cost more than $10,000. Index funds generally can be purchased for a small minimum investment, or with small, regular deposits automatically drawn from a checking account.

Index funds and shares are about equally tax-efficient.

An index fund can reinvest dividends back into the market every day, while a unit investment trust must set aside dividend payouts in interest-bearing accounts until the dividends are paid out at the end of the quarter.

Fund supporters call this a "cash drag," but it actually cuts both ways; at times when the market is in decline, the cash drag becomes a "cash boost," actually improving performance.

The one area in which index shares are superior from a tax standpoint is in a market meltdown. Index funds could lose their tax efficiency if shareholders bail out while the market is in free-fall; for reasons too technical to cover here, index shares don't have that potential problem.

Both shares and funds are low-cost investments.

Spiders, for example, have an expense ratio equal to or less than most S&P index funds. That can ease the commission costs.

The big difference between index funds and index shares, therefore, comes down to one of function. Index shares feel like a trading tool, something you use when you want an index for the rest of the month, rather than the rest of your life.

"Funds win hands-down for convenience, but spiders are the better short-term trading vehicle," says Jack Bogle, founder of the Vanguard Group and the leading proponent of index funds. "But the merits of indexing come from holding the index forever. If people are tempted to trade an index, they could be timing the market, and those kind of moves wreck indexing."

There are more than 50 varieties of World Equity Benchmark shares, or WEBS, which index the market of a specific country or region of the world. There are many different species of spiders, such as "select sector" spiders that track a specific industry.

DIAMONDS (the acronym was so long even the exchange people can't remember it) track the Dow Jones industrial index, while the Nasdaq 100 tracking stock is called by its ticker symbol, QQQ. Recently, Merrill Lynch & Co. launched a new vehicle called Internet HOLDRs (for Holding Company Depositary Receipts), which track a fixed basket of 20 Internet stocks.

Clearly, most index shares are designed for the pros, not the average investor. Only the broadest of the index shares are a worthy index fund substitute and only when held long-term.

Still, the explosion of index shares is likely to continue. Michael T. Bickford, senior vice president for derivative marketing and research at the AMEX, acknowledges that there may eventually be index shares modeling almost anything. "We have created an enhanced mousetrap for index funds, and there is a lot of demand for new products."

Ultimately, the question for investors may not be index funds vs. index shares, but which variety is right. In either case, an investor who picks the wrong investment strategy will be left holding the bag.

Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, MA 02107-2378.

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