Getting Started with Exchange-Traded Equity Funds (ETFs)

Conceived more than 80 years ago and now owned by 91 million individuals from 54 million households in the U.S., mutual funds owe their strong appeal to a combination of features: professional management, instant diversification for low minimum investments, prices based on net asset value (NAV) and marked to market daily, and easy reinvestment of dividends and capital gains.

Known legally as open-end investment companies, they issue new shares when investors want to buy them at NAV per share — plus sales charges unless they are no-load funds — but they must redeem shares at NAV (less sales charges unless they are no-load funds) when holders want to sell.

These characteristics have long distinguished mutual funds from a second type of investment company, closed-end funds, whose issued shares are fixed at creation. This means that bid-and-ask prices may be above or below NAVs.

The third type of investment company is Unit Investment Trusts, which are a fixed basket of stocks (not an evolving index) held for a pre-determined time.

If mutual funds have been found by some to be lacking a feature, it often has been the opportunity to buy or sell their shares at any time when markets are open at known prices — just like publicly traded stocks, bonds, and closed-end investment companies.

Exchange-traded “equity” funds (ETFs) were introduced in 1993 by a subsidiary of the American Stock Exchange. They are designed to give investors a vehicle that resembles mutual funds but also provides the opportunity to have buy or sell orders promptly executed at known prices on a securities exchange (through a broker) whenever markets are open.

Named the SPDR Trust, whose shares were referred to as “Spider (for SPDR, or Standard & Poor's Depositary Receipt), the first ETF was formed as a UIT with the investment objective of tracking the S&P 500 Index, thereby permitting its portfolio to be changed when S&P changed the composition of its index.

Its investment policies thus were similar to those of the mutual funds that had been passively managed to match the performance of the S&P 500, beginning with Vanguard 500 in 1976, or other domestic and foreign stock and bond price indices.

Over the next three years, three more ETFs, organized as UITs, followed the SPDR model, matching the following underlying stock indices, the S&P MidCap 400, the Dow Jones Industrial Average, and the NASDAQ 100. By 1996, a major change occurred when the first two ETFs organized as open-end investment companies were introduced.

ETFs have experienced phenomenal growth. By the end of 2005, ETF total assets had reached $296 billion. Some 193 ETFs were organized as open-end funds, representing 68 percent of total ETF assets and eight were organized as UITs, representing 32 percent. At the time, as much as 63 percent of ETF assets were broadly diversified across domestic equity sectors while 10 percent were concentrated in individual market sectors or industries. Another 22 percent of ETF assets were invested internationally; the remaining 5 percent, in bonds.

Why have ETFs been so successful in attracting investors?

June 2006 - This column is produced by the Financial Planning Association, a membership organization for the financial planning community, and is provided by Terry Green, CFP, AIF, a local member of the FPA.