Frequently Asked Questions about ETFs

By Index Funds Staff

What is an ETF?
An exchange-traded fund is a mutual fund that trades like a single stock. Until the development of the ETF, this was never before possible. An ETF is a basket of stocks that reflects the composition of an index, like the S&P 500 or the Nasdaq 100. The ETF's trading value is based on the net asset value of the underlying stocks that it represents. Think of it as a mutual fund that you can buy and sell in real time at a price that changes throughout the day.

What are the benefits of using ETFs?
Essentially, with ETFs, you enjoy both the flexibility of a stock and the diversification of an index fund. While most mutual funds are priced at their net asset value (NAV) at 4:00 p.m. daily, the price of the ETF changes in real time throughout the day. ETFs can also be bought on margin (money borrowed from your broker) and sold short. Unlike regular stocks, ETFs can also be sold short on a downtick (in a market that is moving down).

In addition to having both the benefits of flexibility and diversity, the expense ratios for most ETFs are extremely low. Also, since the underlying components of an ETF basket remain constant, the fund is not forced to sell stocks when investors sell their shares. Often, when traditional mutual fund investors sell all or part of their investment, all of the investors in that fund suffer capital gains tax consequences. While ETF investors may suffer capital gains costs as the result of dividend payouts or index rebalancing, they do not suffer these consequences from redemptions in the fund.

Are there any negatives?
While the expense ratios of ETFs are low, and the funds are generally very tax efficient, there are certain costs that are unique to ETFs. Since ETFs, like stocks, are bought as shares through a broker, every time an investor makes a purchase he pays a commission to his broker of $8 and up depending on the broker and the amount of shares purchased. In addition, the ETF investor can suffer from the usual costs of trading stocks, including differences in the ask-bid spread, unexecuted trades, etc. Of course, mutual fund investors are also subjected to the same trading costs indirectly, as their fund managers must pay costs to buy the stocks that are in the fund. Nonetheless, since large managers are buying in bulk, they can limit trading costs in the way that a small investor cannot.

One other potential cost/benefit for the ETF investor is unique to ETFs. This is the premium/discount that the ETF is trading to its underlying net asset value. While ETFs are tied to a basket of underlying stocks, the trading of the ETF is theoretically unrelated to the actual stocks it holds. What generally keeps the trading and net asset values very similar is arbitrage. If an investor thinks that he can capitalize on a difference in the two values, he can buy a large number of shares at a discount and redeem them for the actual shares to realize a profit. This is what generally keeps the values so close together. Traders will step in to profit from very small differences in the trading and net asset values.

How can I buy and sell ETFs?
All U.S.-based ETFs currently trade on the American Stock Exchange (AMEX), though the New York Stock Exchange (NYSE) plans to introduce ETFs in the near future. Shares can be purchased the same way you would purchase a normal stock. Like individual stocks, ETFs have ticker symbols (like DIA or QQQ) and can be purchased through your broker. Likewise you sell shares in an ETF the same way you would sell shares of a normal stock.

How are ETFs created and redeemed?
What basically happens is that a market maker or "authorized participant" essentially loans an entire portfolio of shares to the fund manager. The stocks are then placed in a trust and shares of the ETF are created, generally in a creation unit of 50,000 shares. ETF shares are sold and resold freely among investors on the open market. If he purchases a sufficient amount of shares, an investor can exchange one full creation unit of ETF shares for the underlying shares of stock. The ETF creation unit is then destroyed and the underlying stocks are delivered out of the trust.

What ETFs are available on the market?
Including the Merrill Lynch HOLDRS, which are set baskets of stocks that don't change like a regular ETF, there were 93 U.S.-based ETFs on the market as of October 20, 2000, with many more due to hit the market in coming months. For a complete, regularly updated listing of all these ETFs, as well as complete factual information and data on each please click here.

How can I use ETFs in managing my portfolio?
The diversity of ETFs matches the diversity of the market. By using ETF offerings of the total market, value, growth, large and small stock indexes, and of sectors-specific and international regional and single-country offerings, investors can fully diversify the equity part of their portfolio solely by using ETFs.

How much money is in ETFs and how fast is that number growing?
Excluding Merrill Lynch HOLDRS, as of 3/30/2001, the amount of assets under management in ETF funds had reached $75.8 billion. From the beginning of 1998 to the end of 2000, assets under management in ETFs grew nearly tenfold. The first U.S.-based ETF, the S&P 500 SPDR (SPY) opened in 1993.

Year End	1993	1994	1995	1996	1997	1998	1999	2000
Assets (Millions$)	461.3	419.2	1,053.5	2,404.2	6,709.5	15,628.4	33,908.1	65,257.8

Source: American Stock Exchange, excludes HOLDRs

What is cash equitization?
While investors generally like to be as fully invested in the stock market as possible, they often need to hold some cash to give them flexibility in their investment decisions. Converting this cash to very liquid ETF holdings, allows investors, particularly large investors to remain in the market, while ensuring that the assets are very easy to convert to cash for reinvestment.

What future products we can expect ETF managers to develop?
ETF fund managers are actively exploring their options. Assuming that significant regulatory and logistical obstacles can be overcome a variety of new products are likely to enter the market. There has been talk of fixed-income ETFs, an expansion into other market sectors and other regions of the world, and the Holy Grail of ETF fund managers: expansion into actively picked stock funds.

Will ETFs make traditional mutual funds obsolete?
Ah yes, the $64,000 question...Both sides claim that they are not after the other's market, but Vanguard recent announcement that it would enter the fray despite having serious reservations about ETFs was very telling. The primary obstacle preventing a revolutionary shift is trading costs. The cost of dollar-cost averaging with ETFs is prohibitive. Rest assured, though, the ETF fund managers are looking for ways to tap into the vast pools of retirement capital.

10/19/2000