TCS Daily


An Alternative for Mutual Betrayal

By James K. Glassman - October 31, 2003 12:00 AM

The mutual fund scandals are spreading. New revelations show that more and more managers betrayed the mass of their customers by illegally favoring a few fast-buck artists. Dumb and dumber.

While Morningstar, the respected research firm, has recommended that investors avoid funds run by Bank of America, Bank One, Strong Capital Management, Fred Alger and Janus -- implicated in the initial charges -- I still advise restraint. If you own good funds that are under scrutiny by the authorities, hold on to them for now, until more facts come to light. But if the funds are marginal performers, dump them -- recognizing the tax consequences, of course.

Even if the shenanigans prove isolated, however, this is a good time to consider alternatives to conventional mutual funds.

The best choices fall under the broad rubric "exchange-traded funds," or ETFs. These are portfolios of stocks or bonds that track an index through computerized, or passive, management and are listed on the major stock exchanges. They are traded as if they were individual companies, just like the stock of, say, General Motors or Intel.

ETFs have advantages over open-end, or conventional, mutual funds, which are not traded on exchanges but instead are priced according to their net asset value (NAV) at a particular point in time, usually 4 p.m. Eastern. The NAV is determined by adding up the stock market value of all the holdings in a mutual fund's portfolio and dividing by the number of shares outstanding in the fund.

The practices that led to the recent mutual fund scandals exploited the difference between "stale" NAVs and real-time stock prices, especially in overseas markets.

By contrast, the price of an ETF, like the price of GM, is whatever the market says it is from moment to moment. Perhaps unscrupulous charlatans can figure out ways to cheat in the ETF market as well, but it's doubtful. In fact, traders are continually trying to make money on the difference between the market price of an ETF and the value of the stocks in the index on which it is based. Such arbitrage is helpful because it keeps market prices and NAVs tightly connected, as studies have shown.

I will admit to being an ETF junkie. There are advantages to ETFs, understood by investors long before anyone had an inkling of scandals. One is that they charge far lower annual expense ratios than conventional mutual funds -- an average of less than one-fourth of a percentage point, compared with more than a full point. (Remember, however, that you have to pay brokerage commissions to buy ETFs while no-load mutual funds are commission-free. If your broker charges, say, a flat $30 for an ETF purchase worth $10,000, that's an expense of 0.3 percent.) Another benefit of ETFs is that trading is swift and easy and contemporaneous. If you want to get out at 2:11 p.m., it will take only seconds to call your broker or make an online trade and get the price at that instant.

Unlike mutual funds, ETF shares can also be purchased on margin. You can sell them short (meaning that you borrow them from another investor, selling them at today's price in the hope that you can buy them back later at a lower price and make a profit on the difference). By the way, I don't recommend either of these practices.

You can use stop orders and limit orders, giving your broker instructions on when to automatically buy and sell shares. And, if you want, you can buy just one share of an ETF, in most cases for less than $100. Mutual funds, by contrast, require minimum starting investments that average about $2,000.

ETFs allow no human intervention in the picking of stocks. You are buying the shares of an index, not the choices of a manager. That can be an advantage -- the track records of active managers as a group aren't too inspiring. Yes, some managers can beat the indexes, but they don't wear big red badges so you can pick them out in advance.

The ETF business is booming. There are now 117 ETFs, according to the Investment Company Institute, a trade group, compared with just 30 as recently as 1999. The funds have total assets of $117 billion, compared with less than $5 billion just five years ago.

The first ETF, which tracks the Standard & Poor's 500-stock index, the benchmark for most investment managers, was launched just 10 years ago. It is called officially the SPDR (for Standard & Poor's Depositary Receipts) Trust Series I, but the shares are more affectionately known as "Spiders," trading on the American Stock Exchange under the symbol SPY. The price of a Spiders share is one-tenth the value of the S&P. So today, with the S&P around 1000, a Spiders share costs about $100.

In other words, you buy just one share of stock but you get little pieces of the 500 biggest U.S. companies. Spiders technically comprise a large-cap portfolio. But they offer a good way to own nearly the entire market, since the capitalization (or stock value) of the 500 is about nine-tenths that of the market as a whole. Spiders carry an expense ratio of just 11 basis points (or 0.11 percent).

Another S&P-tracking ETF, called iShares S&P 500 (IVV), charges even less: a mere 9 basis points. The iShares ETFs are managed by Barclays Global Investors, a firm that specializes in index investing (www.ishares.com). A similar choice is Diamonds Trust Series I (DIA), which tracks the Dow Jones industrial average, 30 prime large-cap stocks; it carries annual expenses of 17 basis points. Again, don't forget the brokerage commissions for getting into and out of all ETFs.

On an average day, 43 million shares of Spiders change hands (compared with fewer than 1 million shares of IVV and 8 million shares of DIA), valued currently at more than $4 billion. Spiders typically rank daily among the top 10 securities of any sort traded on all U.S. exchanges.

Even more popular is an ETF based on the Nasdaq 100 index (QQQ), the largest companies listed on America's second-largest stock market. Owning QQQ is an easy way to hold the tech sector, since the index includes such companies as eBay (EBAY), Cisco Systems (CSCO) and Amazon (AMZN). But it also includes such retailers as Ross Stores (ROST), grocery chains such as Whole Foods Market (WFMI) and health-care firms such as Gilead Sciences (GILD). On an average day, 74 million shares of QQQ are traded, and it is usually one of the three most active issues.

An excellent special section in the October issue of the AAII Journal, the monthly publication of the American Association of Individual Investors (www.aaii.org), lists all the ETFs, with such information as their symbols, recent returns, volume, expense ratios and risk. QQQ, for example, has been 84 percent more risky than a "portfolio of all stocks worldwide during normal market conditions."

That's an important lesson. An ETF's diversification doesn't necessarily mean it offers a smooth ride. QQQ made its debut in early 1999 at $50 a share and quickly soared to a peak of $120.50 on March 24, 2000. Then, with the tech crash, shares skidded below $20 by October 2000. They're now at $34.20. For owners of QQQ, including me, this volatility has been unsettling but sometimes rewarding. So far in 2003, QQQ is up 32 percent (see www.nasdaq.com for all the details). QQQ's expense ratio is just 20 basis points.

Other tech ETFs include Select Sector SPDR Fund-Technology (XLK), which includes all the technology stocks in the S&P 500 index (see www.spdrindex.com for information on all the S&P-based ETFs); iShares Goldman Sachs Technology Index (IGM); and more specialized tech ETFs such as Merrill Lynch Semiconductor Holdrs (SMH) and StreetTracks Morgan Stanley Internet Index (MII).

Merrill's Holdrs ETFs carry especially low expense ratios (just 8 basis points) and are structured as grantor trusts. You actually own the underlying shares, which can mean minor bookkeeping headaches when a company spins off a subsidiary but also means that you can get all the annual reports -- which I like. For trading purposes, however, Holdrs (an acronym for "holding company depositary receipts") operate like any other ETF. The Holdrs Web site is www.holdrs.com. The site for StreetTracks, managed by State Street Global Advisors, is www.streettracks.com.

ETFs allow you to fill in gaps in your portfolio to give it the kind of balance that dampens volatility. For example, if you're like most investors you have a hard time assessing small-cap stocks. But you need small-caps for true diversification, so buy iShares Russell 2000 Index Fund (IWM), which is based on the Russell 2000, the small-cap benchmark. For mid-caps, a good choice is MidCap SPDR Trust Series I (MDY), based on the S&P MidCap 400 Index, or a relatively new ETF, Vanguard Extended Market Vipers (VXF), launched last year by the mutual fund house and based on the Wilshire 4500 index.

Vanguard (www.vanguard.com) has a reputation for low expenses. The mid-cap ETF carries a ratio of 20 basis points while Vanguard Total Stock Market Vipers, based on the Wilshire 5000 Index, which captures the value of all U.S. stocks, charges just 15 basis points.

Vanguard also provides the toughest competition to Spiders, with its Index 500 open-end mutual (VFINX). I'm often asked which is a better buy. The mutual fund charges higher annual expenses (18 basis points vs. 11), but the difference is minimal. For a $10,000 investment, it's a matter of seven bucks, and don't forget the commissions on the ETFs. Spiders give you more trading flexibility. Mutual funds discourage market timing -- jumping in and out -- but, then again, market timing is a poor investing strategy anyway.

There is a small tax advantage to Spiders because a mutual fund sometimes has to sell shares to meet redemptions, thus incurring capital gains, but, again, the difference is tiny. In the end, the choice is personal.

Perhaps the best use of ETFs is to buy, at relatively low cost, bundles of stocks in a small sector that interests you. For example, iShares offers 21 separate single-country ETFs, from Austria (EWO) to Hong Kong (EWH) to South Africa (EZA). They're each based on the Morgan Stanley index that reflects the value and composition of the local stock market. Expense ratios are higher than those for domestic ETFs -- just under 1 percent -- but worth it since the transaction costs would be high if you tried to buy the underlying stocks yourself. Closed-end funds, which also trade on exchanges, specialize in individual countries as well, but their portfolios are picked by human managers. Can they beat the indexes? Sometimes. But for smaller countries, I much prefer iShares.

There are ETFs that focus on utility stocks, on real estate investment trusts, on energy stocks, biotech, natural resources, and on and on. You can even buy ETFs whose portfolios comprise Treasury bonds with specific maturities (one to three years, seven to 10 years, etc.) The variety keeps growing, and, at a time when scandal and uncertainty shroud conventional mutual funds, it's wonderful to have an alternative.

Of the ETFs mentioned in this article, James K. Glassman owns Spiders, QQQ, iShares S&P MidCap and Select Sector SPDR Fund-Technology.

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