Retail Investor Perception of Exchange-Traded Funds By John Spence February 23, 2001

The biggest players in exchange-traded funds, Barclays Global Investors (BGI) and State Street Global Advisors (SSgA), truly believe they've pioneered a tool that's perfect for index investors - low management fees, protection from taxes and turnover, and reduced index tracking error. If only people knew how great these things were, then the cash would just roll in, they figure.

BGI says that it plans to shell out over $20 million in 2001 on television advertising, direct mail, and Internet development to educate retail investors on ETFs. SSgA, which launched the first U.S. ETF (SPY), has announced it will roll out more ETFs based on domestic and international indexes. "What SSgA and the AMEX did to the investment industry with the introduction of the ETF in 1993. . . they're about to do again," trumpets a recent State Street ad.

But are index investors listening?

Financial Research Corporation (FRC) wanted to find out. In a new study, FRC polled 892 investors to gauge how retail investors really view ETFs.

Very few of the respondents - approximately 2% - had actually invested in ETFs, and only 41% were moderately or very informed about them, but all were financial decision-makers controlling assets. Not surprisingly, investor familiarity with ETFs tended to rise with investable asset levels.

Participants were also asked to rank the perceived benefits of ETFs. The table below shows which features of ETFs they found most advantageous.

Primary Reasons for Potential ETF Interest
Rank	ETF Feature/Benefit	% of Respondents Indicating Primary Reason for Potential Interest
1	Tax efficiency	55%
2	Trading & tax flexibility	48%
3	Lower expense ratios	46%
4	Diversification	39%
5	Invest in entire market sector	37%
6	Access to sectors/indices not available with mutual funds	35%
7	Continuous pricing	26%

Source: Financial Research Corporation

"Given what you hear in the media, you would guess the most attractive features would be continuous pricing and trading and tax flexibility," said FRC's Gavin Quill, author of the study.

Ranked dead last was continuous pricing, a result that doesn't appear to correlate with the notion that trade-happy investors will gravitate to ETFs.

The top three attractions - tax efficiency, trading and tax flexibility, lower expense ratios - reflect growing investor awareness of expenses and how they can devour returns.

Quill takes the view that trading and tax flexibility, which ranked second, does not reflect investor desire to use ETFs as active trading tools. Instead, he believes timing flexibility gives investors a feeling of increased control and security when they do decide to trade.

"Just because ETF investors can trade all day doesn't mean they will trade all day," said Quill.

Many studies have shown that heavy trading in any security leads to high expenses that are extremely difficult to overcome through superior stock-picking. Clearly, FRC's study turned up lots of buy-and-hold investors interested in ETFs who are quite aware that their final returns after tax are the only true measure of success.