The new funds that trade like stocks require extra caution

Your Money

February 06, 2005|By BILL BARNHART

The latest investment fad, known as ETFs, may have to change its name from exchange traded funds.

If financial engineers and Wall Street marketing wizards have their way, ETFs will be known as "everything that fits."

The first and still most popular ETFs are simple baskets of stocks representing well-known stock indexes such as the Standard & Poor's 500 index and the Nasdaq 100 index.

Shares of the basket trade continuously, like common shares, on stock exchanges. Most mutual funds can be bought or sold just once a day.

ETFs, as initially conceived, have many advantages over traditional mutual funds, including lower fees, tax efficiency and, in light of recent mutual fund scandals, less susceptibility to costly human foibles.

But it looks like Wall Street once again is gearing up to sell the sizzle, not the steak.

Last fall, the UBS brokerage won clearance from the Securities and Exchange Commission to sell shares in an ETF-like product called StreetTracks Gold Trust. The basket is gold bars.

The product was launched at the peak of the latest gold rally through a flashy initial public offering.

Commodity-based ETF copycats, including silver and commodity-price indexes, probably are on the way.

Industry buzz concerns ETFs based on actively managed portfolios, rather than passive stock or bond indexes.

To trade them continuously, market makers on stock exchanges need to know what's in the ETF basket. But most active managers are loath to tell, except a few times a year, as the Securities and Exchange Commission requires.

Another idea for an ETF is so-called rules-based portfolios, which would allow investors to trade shares in a transparent and rote investment strategy, rather than a static basket of securities. Firsthand Capital Management filed with the SEC in December for such an ETF.

Last month Barclays Global Investors, the biggest sponsor of ETFs, introduced the iShares Select Social Index Fund. The ETFs are based on shares of companies deemed to be socially responsible. In 2003, Barclays launched the iShares Dow Jones Select Index Fund, holding dividend-paying companies.

The key word is "select," said Steven A. Schoenfeld, chief quantitative strategist at Northern Trust Global Investments. "It means someone is making a selection; it means there is an active element."

In a traditional mutual fund, shareholders have the power to hire and fire managers - the selectors. In an ETF, they don't.

Also on the drawing boards are ETF look-alikes that heavily use borrowed money or futures and options. Some ETF concepts employ a synthetic "index" that is a basket of derivatives.

"We run the risk of all of the 30 years of hard lessons learned about the benefits of stock indexing being dissipated by a massive proliferation of indexes," Schoenfeld said.

ETFs are one of the best investment innovations in the past 20 years, to be sure. But simple stock indexes, which offer the opportunity for long-term, low-cost investing, are even better.

When your broker praises the latest ETF, use the "f" words. Ask him precisely to describe the "fund" and how it "fits" your long-term investment goals.

Bill Barnhart is a columnist for the Chicago Tribune, a Tribune Publishing newspaper. E-mail him at

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