Originally created 11/24/03

Mutual fund woes may boost growth of ETFs

NEW YORK -- With the mutual fund industry increasingly under attack for suspected illegal trading, advisers say investors have other options, including exchange-traded funds and separately managed accounts.

ETFs are baskets of securities that track an index, but can be traded like a stock. Separately managed funds are customized portfolios overseen by professional managers.

Investors might want to consider these options because, with the list of accused fund firms growing each week, replacing implicated mutual funds with shares in other funds isn't a foolproof strategy. It's not certain which fund might be charged with violations next.

"We think as an alternative to mutual funds, they're very good," Deena B. Katz, a certified financial planner in Coral Gables, Fla., said of ETFs and managed accounts. "In light of this whole mutual fund thing, eventually all of this will shake out and funds will be much better."

"But in the short term, it makes people a lot more nervous," she said. "If certain people are going to get out of their funds, they should be invested - they shouldn't go to cash."

ETFs and managed accounts eliminate the danger of market timing, or short-term "in and out" deals, a practice that regulators say is widespread in the fund industry even though fund firms discourage it in their prospectus. Market timing is one of the practices that regulators have been investigating in recent months.

Regulators have said market timing and illegal late trading, in which investors are improperly allowed to trade after the close of markets at preclosing values, costs investors billions of dollars.

Because ETFs trade all day like stocks, there is no "stale pricing" in which mutual funds are priced according to their net asset value once a day. Market timing often exploits the difference between stale prices and real-time stock prices, particularly in overseas markets.

In addition, since ETFs track an index, they have lower fees and more tax efficiency; there is no fund manager making investment decisions and churning the account.

"There can't be any shenanigans," said Tom Roseen, research analyst at Lipper Inc.

The investments have boomed in recent years. Currently there are 115 ETFS compared to 30 in 1999. Total assets have grown to $119.7 billion through the end of September, up from $65.6 billion at the end of 2000.

One disadvantage is that ETFs must be purchased through a broker, so investors pay a commission each time they buy shares. That makes ETFs less practical for everyday investors who prefer to purchase a small set amount of shares each month.

Separately managed accounts, meanwhile, allow investors to hand over their money to a professional manager who then invest in stock, bonds or cash. Managed accounts avoid market timing because the investor is the only customer; there are no other investors in the account whose trading can affect the account's returns.

Managed accounts also have been popular in recent years as investors seek a greater level of customization to their portfolios, with total assets growing to $456 billion this year compared with $417 billion in 2000, according to the Money Management Institute.

But the accounts remain generally inaccessible to everyday investors: the typical minimum investment is $250,000 and fees are higher than other investments, averaging about 2 percent annually, compared with 1.6 percent for domestic mutual funds.

Analysts say ETFs and managed accounts won't ever replace mutual funds, which they say are the best choice for smaller investors who want broad market exposure and professionally managed funds at a low cost.

Indeed, while implicated funds such as Putnam Investments have seen large outflows in recent weeks, investors still poured $24.5 billion into stock mutual funds overall in October, the largest amount since March 2002, according to AMG Data Services.

"There will always be a place for mutual funds," Roseen said. "The allegations will hurt the industry in the short term, but it's very likely people will come back."

On the Net:

AMG Data Services: www.amgdata.com

Lipper Inc.: www.lipperweb.com

The Money Management Institute: www.moneyinstitute.com

Investment Company Institute: www.ici.org


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