NEW YORK -- After more than a decade, exchange-traded funds are finally gaining mainstream acceptance, and in some corners they're even being touted as an alternative for mutual fund investors exasperated by the industry's trading scandals.
Fans of ETFs love them because they're cheap and tax efficent, and in many cases can help streamline the investing process. But they probably aren't the best choice for people with smaller portfolios who want to regularly add to their investments or make short-term trades.
ETFs, which are similar to index mutual funds in that they track specific groups of stocks, had their biggest month ever in December, with net inflows of $12.75 billion. Total assets for the year were $150.98 billion, largely due to market gains, according to the Investment Company Institute, the fund industry's trade group. That's still only about 2 percent of the estimated $7.4 trillion held by mutual funds, but ETFs are poised to gain a greater market share as more money managers become comfortable with them.
The main difference between index mutual funds and ETFs is that ETFs are traded like stocks: Their share price changes throughout the trading day, they can be sold short and bought on margin. Traditional mutual funds are priced once a day, at the end of trading.
Industry experts say institutional investors, who like the greater trading flexibility, make up about half the market. The rest are purchased through advisers and brokers, and about 10 percent are bought by individual investors.
"ETFs are an instrument that has sort of started to come of age in the last couple of years," said John Rea, chief economist with the ICI. "We really need a few more years to see how it evolves ... in the retail sector."
The number of ETFs ballooned from about 80 in 2000 to 133 last month after The Vanguard Group raised its stake with its 14 new VIPER funds. The biggest player remains Barclays, which offers 85 different ETFs, many launched through its iShares family over the last 3 1/2 years.
The firm established its first ETF in 1996, "and for much of that time, our competitors have been saying these are a fad, they're for day traders," said Lee Kranefuss, chief executive of ETF products at Barclays Global Investors.
"Vanguard's action really validates our position," Kranefuss said. "These are a low-cost, tax-efficient, transparent investment vehicle, and that's a very compelling set of ideas."
The average expense ratio for ETFs is 0.47 percent, while the average for index equity mutual funds is 0.90 percent, according to fund tracker Morningstar Inc. For investors with a buy-and-hold approach, ETFs can be more tax efficient than mutual funds, because they tend to have smaller capital gains.
However, paying a brokerage fee each time you buy more shares of an ETF can get quite expensive for small investors. If you're slowly building wealth by investing a portion of every paycheck, mutual funds are a better bargain, said Morningstar analyst Christopher Traulsen.
Suppose you invested in the oldest and biggest ETF - Spiders, short for Standard & Poor's Depositary Receipts, which track the S&P 500. They have an expense ratio of 0.11 percent, meaning that if you invested $10,000 all at once, you'd spend $11 to own it, plus whatever brokerage fees you paid to make the trade. Compare that to the Vanguard 500 index fund, which has an expense ratio of 0.18 percent. The ETF looks cheaper, right?
Imagine investing the same $10,000 over the course of a year, writing a check every month; the brokerage costs and expenses of buying shares of the ETF probably would add up to more than $100, but the cost of owning the similarly traded mutual fund would still be just $18.
"If you're a dollar-cost averager, or even if you're making just a few trades per year, ETFs are probably not a good deal for you," Traulsen said. "ETFs are really best suited for someone who is investing a lump sum of money for the long term, or a rapid trader who is willing to pay the brokerage commissions."
ETFs can be great tools when used correctly. Money managers will often "park" cash in an ETF while they're looking for a more strategic investment. Some like knowing precisely what stocks are held in an ETF, an edge they might not have with mutual funds. And because they track specific indexes, ETFs avoid "style drift," which happens when a mutual fund shifts from its stated approach.
"With all the stuff going on in the fund industry, ETFs are a great option if you're looking to invest in an asset class quickly," said Thomas F. Lydon Jr., president of Global Trends Investments in Newport Beach, Calif. "ETFs offer great diversification quickly, and you know what you're buying."
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