Exchange Traded Funds

Exchange-traded funds have a fast-growing fan club whose membership includes pension plans, hedge funds and professional investors and traders. Basically, ETFs are like an index mutual fund that can be traded throughout the day like a stock. You can't do this with mutual funds that are priced once a day when the market closes. So far, though, ETFs haven't been suitable for small investors who put a little each week or month in the markets. The reason is simple: commissions. Each time investors buy or sell an ETF, they pay a brokerage commission.

If you own mutual funds outside a retirement account, you likely have heard from the investment companies asking you to choose your math. The companies want you to select the method they should use to calculate your "cost basis" — how much you paid for the shares. What you decide can make a difference in your tax bill when you sell. The fund companies are acting on legislation passed in 2008 that requires brokerages and investment companies to report cost-basis information to the Internal Revenue Service when securities are sold.

Buy a broad mix of stocks and bonds. Keep expenses low. Don't bother trying to beat the market's average return. That's been the mantra of index mutual funds since John Bogle, founder of the Vanguard Group Inc., introduced the first one in 1976. For many investors, the strategy has paid off. Now, the next generation of index investing - exchange-traded funds, known as ETFs - is coming of age and attracting a lot of attention. Like index mutual funds, ETFs buy a basket of stocks or bonds that mimic a particular market benchmark, such as the Standard & Poor's 500. But, in a twist on Bogle's creation, ETFs can be traded on the market throughout the day like an individual stock.

W ith more than 900 exchange-traded funds, you can find one that fits every investment sector, strategy or mood you're in. Now get ready for even more variety with actively managed ETFs. This new product combines the tax and cost advantages of a regular ETF with the expertise of a professional money manager that you get with most mutual funds. Baltimore's Legg Mason and T. Rowe Price Associates, along with other fund companies such as Vanguard Group and John Hancock Funds, are seeking approval from the Securities and Exchange Commission to offer actively managed ETFs.

Exchange-traded funds have become a hot item among investors, but financial advisers warn that, despite their prominence, the funds are not necessarily right for everyone. Called ETFs, the funds are a cross between an individual stock and a mutual fund. They invest in an index, such as the Standard and Poor's 500, the way index mutual funds do. But investors can buy and sell them instantly throughout the day, just as they would stocks. "ETFs fill a nice niche but for most individual investors, utilizing a no-load indexed mutual fund might be more appropriate and more suitable," said Bryan Thaler, an investment counselor at the money management firm VanSant and Mewshaw in Lutherville.

An explosion of new exchange-traded funds hitting the market is giving investors more ways to put their money to work every day. But how many do they really want? Exchange-traded funds, or ETFs, have attracted hundreds of billions of dollars as an alternative to mutual fund investments in recent years. Mutual funds still pull in much more client money than exchange-traded funds, but ETFs have established themselves this decade as competitive products that appeal to many investors. Their assets, just $130 billion at the end of 2003, had grown to $480 billion by May. Investment management companies have responded to that kind of demand by burying investors in new products.

Baltimore's Legg Mason Inc. filed an application Monday with the Securities and Exchange Commission to launch actively managed Exchange-Traded Funds. Actively managed ETFs have been around for about two years and there are now less than two dozen, although that number is expected to grow. In December, Baltimore's T. Rowe Price Associates also filed an application with the SEC to launch a series of active ETFs. ETFs are similar to index mutual funds but can be traded throughout the day like a stock.

If you own mutual funds outside a retirement account, you likely have heard from the investment companies asking you to choose your math. The companies want you to select the method they should use to calculate your "cost basis" — how much you paid for the shares. What you decide can make a difference in your tax bill when you sell. The fund companies are acting on legislation passed in 2008 that requires brokerages and investment companies to report cost-basis information to the Internal Revenue Service when securities are sold.

Roseann, a reader from Baltimore, says the investment returns on her mutual funds are being eaten up by fees. She complained to her financial adviser, who recommended exchange-traded funds, or ETFs. Roseann says she doesn't know much about ETFs. But she's interested in getting more from the mutual funds that make up one-third of her nest egg. What are ETFs? she recently called to ask. And what are the pros and cons? ETFs are basically index mutual funds that trade on an exchange like stocks.

There will be a raft of exchange-traded funds opening the rest of this year, but chances are that investors should ignore most of the new issues. The expected creation of hundreds of new funds is the logical outcome of two rules proposals, and one rule change, approved by the Securities and Exchange Commission last week. If passed, as expected, after a comment period, the rules will streamline the approval process for ETFs, turning something that was tedious, time-consuming and difficult into a walk in the park.

Baltimore's Legg Mason Inc. filed an application Monday with the Securities and Exchange Commission to launch actively managed Exchange-Traded Funds. Actively managed ETFs have been around for about two years and there are now less than two dozen, although that number is expected to grow. In December, Baltimore's T. Rowe Price Associates also filed an application with the SEC to launch a series of active ETFs. ETFs are similar to index mutual funds but can be traded throughout the day like a stock.

The mutual fund, time-honored champion of small investors, is facing a fast-rising challenger in the exchange-traded fund. They are fighting for your investment dollars. Although ETFs are much smaller, some experts predict they ultimately will win the long-term confrontation. "In a year such as 2008, when returns are low or negative, every 50 basis points [half of a percentage point] make a difference," said Tom Anderson, head of ETF research at State Street Global Advisors in Boston.

High investment costs remain out of mind when overall returns are strong. Why sweat decimal points when basking in 20 percent gains? But when returns turn meager or slide downward, hefty expenses become visible and painful. Although investors can find low-cost mutual funds, exchange-traded funds and bank accounts these days, it requires research and willingness to read fine print. "Keeping investment expenses low was important a decade ago, but now is critical," said Harold Evensky, certified financial planner with Evensky & Katz in Coral Gables, Fla. "You can't control markets, but you have some control over expenses, and that is important in a low-return environment."

There will be a raft of exchange-traded funds opening the rest of this year, but chances are that investors should ignore most of the new issues. The expected creation of hundreds of new funds is the logical outcome of two rules proposals, and one rule change, approved by the Securities and Exchange Commission last week. If passed, as expected, after a comment period, the rules will streamline the approval process for ETFs, turning something that was tedious, time-consuming and difficult into a walk in the park.

My youngest daughter received some tarot cards and an instruction book as a holiday gift, and asked me if I knew how to use them. I told her I didn't need cards to foretell the future, because each year around this time I use my intuition - and some really good industry contacts - to predict the big stories the fund industry will see in the coming 12 months. Since I started making prognostications in 1996, about 5 calls in 7 have hit the target, with one forecast being a bit too early and one being just plain wrong.

An explosion of new exchange-traded funds hitting the market is giving investors more ways to put their money to work every day. But how many do they really want? Exchange-traded funds, or ETFs, have attracted hundreds of billions of dollars as an alternative to mutual fund investments in recent years. Mutual funds still pull in much more client money than exchange-traded funds, but ETFs have established themselves this decade as competitive products that appeal to many investors. Their assets, just $130 billion at the end of 2003, had grown to $480 billion by May. Investment management companies have responded to that kind of demand by burying investors in new products.

High investment costs remain out of mind when overall returns are strong. Why sweat decimal points when basking in 20 percent gains? But when returns turn meager or slide downward, hefty expenses become visible and painful. Although investors can find low-cost mutual funds, exchange-traded funds and bank accounts these days, it requires research and willingness to read fine print. "Keeping investment expenses low was important a decade ago, but now is critical," said Harold Evensky, certified financial planner with Evensky & Katz in Coral Gables, Fla. "You can't control markets, but you have some control over expenses, and that is important in a low-return environment."

IN THE mutual fund business, the most important year is always the one that lies ahead. With that in mind, here is my annual attempt to call the shots on the big stories for 2000. Since I started this ritual back in 1995, about five in every seven calls have come out right, with most of the rest being premature, ahead-of-their-time predictions that simply took longer than anticipated to materialize. Not wanting to volunteer to look stupid, I long ago stopped forecasting the market. But I am not afraid to predict that fund investors will see the following things in the next 12 months: Layoffs at major fund companies.

Buy a broad mix of stocks and bonds. Keep expenses low. Don't bother trying to beat the market's average return. That's been the mantra of index mutual funds since John Bogle, founder of the Vanguard Group Inc., introduced the first one in 1976. For many investors, the strategy has paid off. Now, the next generation of index investing - exchange-traded funds, known as ETFs - is coming of age and attracting a lot of attention. Like index mutual funds, ETFs buy a basket of stocks or bonds that mimic a particular market benchmark, such as the Standard & Poor's 500. But, in a twist on Bogle's creation, ETFs can be traded on the market throughout the day like an individual stock.

It's been a longstanding complaint of some mutual fund investors: Try to bail out at the start of a day when the market is cratering, and you'll find you're strapped in until trading ends, when the fund company prices the fund and makes all transactions for the day. That may be changing. Rydex Investments, of Rockville, Md., has priced its mutual funds twice a day for about the last six years, but the intra-day pricing was only available for customers making trades directly with Rydex.