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Exchange Traded Funds: A new viable alternative for investors

By: Investor Solutions

By: Investor Solutions, Inc.

The explosion of product offerings in the Exchange Traded Fund (ETF) universe offers investors viable alternatives to the traditional index mutual fund. While the total product available today falls short of $100 billion, or less than the some of the largest single mutual funds, the growth curve is staggering. The ETF has been embraced by both institutions and individual investors, and has unique characteristics that make it attractive to both markets. Certainly, ETF’s will be a potent force in future markets.

While there are significant differences, both offer passive investing, low cost, tax efficient, pure market exposure that replicates closely a widely followed index. In short, either are excellent choices for an investor seeking to build an effective asset allocation plan.

Index fund features

To recap, an index fund is a traditional open-ended mutual fund that seeks to replicate the performance of a selected index. Purchases and sales take place directly between investors and the fund. Pricing is fixed for both transactions at the close of business each trading day when the Net Asset Value (NAV) is determined. Because all transactions occur between the fund and individual investor, the fund must maintain a portion of its assets in cash to provide for liquidity, and redemptions may cause tax implications to remaining investors.

ETF features

An ETF, by comparison, is created or redeemed in large lots by institutional investors. After creation, the shares trade between investors like a stock. So, transactions between investors do not affect the fund. This relieves the fund from the obligation to hold as much cash, and bypasses some possible tax problems for remaining investors. While much is made of these two advantages in marketing material for ETF’s, in practice these issues are insignificant for established funds.

Because ETF shares trade freely and continuously the market determines prices, and investors can buy or sell at any time that the markets are open. ETF’s can be sold short, and are exempt from the “up-tick” rule. Those provisions are important to traders and speculators, but of little interest to long term investors.

As previously mentioned, ETF’s are priced continuously by the market so there is a potential for trading to take place at other than the NAV. However, because large institutions can create or redeem ETF’s at any time, these larger institutions take advantage of any significant mispricing through a simultaneous purchase and sale transaction called arbitrage. Arbitrage offers a small but risk free profit to the institution, while forcing prices to remain close to their NAV.

The bottom line

ETF’s and Index Funds are so much alike that for many uses they are almost interchangeable. For long term investors the most significant considerations may be expenses and acquisition costs. These costs vary from firm to firm and plan to plan. So, investors will have to make an assessment of their unique situation.

In general, because ETF’s have fewer customer support costs, they can offer lower expense ratios than an index fund. (This isn’t always the case, so check the fund’s prospectuses.)

On the other hand, many index mutual funds can be acquired without commission or other cost. But, the commission costs to acquire EFT’s can be significant. For instance, an investor making small repeat purchases of ETF’s may incur enormous transaction costs relative to a direct purchase from a no-load mutual fund family. She might not re-capture these costs through lower fees in any foreseeable time frame.