Traded funds may be trend T. Rowe Price can't let pass

September 17, 2006|By Jay Hancock | Jay Hancock,Sun Columnist

T. Rowe Price has always shamed the "innovate or die" crowd.

It focuses on one product: the actively managed, open-ended, no-load, peer-beating mutual fund. It delivers that product come hell or Nasdaq collapse. By avoiding fads, Price has returned an annual average of 20 percent to its stockholders over the past decade.

But there is one innovation that the Baltimore firm might not be able to ignore. Exchange-traded mutual funds, bought and sold on a stock exchange like shares of IBM or Intel, are growing faster than traditional funds and might pressure Price to expand its product line.

The company indicates no plans for ETFs beyond making other firms' ETFs available to its brokerage customers, who have been able to buy ETFs or any stock for years.

"It is a product category we actively track and monitor," Price said in a written response to my questions. However, it added, "There are costs associated with manufacturing and distributing ETFs. Therefore, there needs to be a sufficient market opportunity to justify the investment."

But the market opportunity is growing.

There are thousands of mutual funds but only 268 ETFs, most of which are index-tracking stock funds. Traditional stock mutual funds, with $5.2 trillion in assets, still dwarf ETFs, with $337 billion, according to the Investment Company Institute, a mutual fund trade association.

ETFs, however, are getting a much bigger portion of new fund money than their small market share might seem to warrant. Net fund flows into ETFs for the year through July were $32 billion compared with $84 billion for traditional stock funds, according to ICI. Assets in ETFs grew by a third in the year ended in July, while assets in traditional stock mutual funds rose by 12 percent.

Unlike open-ended mutual funds, which set a price once a day, ETFs trade all day on an exchange. Unlike closed-end mutual funds, which are sold on exchanges but whose trading prices often diverge from underlying values, ETFs' internal components are sometimes redeemed without liquidating the fund. That keeps market and intrinsic values in sync.

Created in the 1990s, ETFs don't seem to play to Price's strengths or philosophy. The company encourages clients to invest for the long term, not buy and sell funds through the day.

While ETFs have very low management expenses, investors must pay a broker to buy or sell them, which often wipes out any cost advantage. Adding to an ETF each month to build a nest egg, as with a 401(k) plan, is impractical because broker commissions would be ridiculous.

But ETFs offer advantages that buy-and-hold investors - and eventually Price - might find attractive. The company says its clients have "low awareness and knowledge" of ETFs, but adds, "We expect that this awareness will improve over time."

The average ETF costs 0.39 percent in management expenses, while the average index fund costs 0.91 percent, according to Lipper Inc.

Because ETFs don't constantly buy and sell stocks to accommodate entering and exiting money, they can have better tax consequences and lower expenses than open-ended funds.

Regular funds in taxable accounts - even index funds - often hit investors with yearly capital gains taxes. That costs money as well as bookkeeping aggravation.

But when ETF investors bail out, they usually just sell shares on the exchange, meaning the underlying stocks aren't dumped, meaning no capital-gains tax at that time.

Retiring baby boomers should like ETFs. Having built up retirement kitties through monthly purchases, boomers can roll the money into ETFs in a lump, pay a one-time broker commission and then enjoy management expenses that are even lower than some of the cheapest conventional index funds.

Vanguard's Total Stock Market ETF, for example, brags an expense ratio of only 0.07 percent. Vanguard's open-ended counterpart costs more than double - 0.19 percent. Vanguard, Price's archrival, has more than 25 ETFs.

Projection: $1 trillion

Financial Research Corp. projects that ETF assets will hit $1 trillion by 2010, which by the Lipper expense ratio of 0.39 percent would generate $3.9 billion in fees. That's a market opportunity that might get Price's attention. Price also might become interested if the Securities and Exchange Commission gives a green light for actively managed ETFs, a product in which it should have a comparative advantage.

Too big to avoid?

For years, Price resisted index funds, another Vanguard staple, before jumping in. My guess is that eventually ETFs, too, will become too big for it to avoid. The company is known for ignoring fads, but ETFs aren't a fad.

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