For a while late last year and early this year, it seemed that one mutual fund family after another was being implicated in some sort of scandal. In fact, the widening scandal included some of the nation’s most recognizable fund companies, including Janus Capital Management and Alliance Capital Management. (See “How Do the Mutual Fund Scandals Affect You?” on blackenterprise.com.) Investors began asking themselves, “Is there any place we can turn to avoid being ripped off?”
“We prefer exchange-traded funds, or ETFs, relative to mutual funds,” says Sean Clark, chief investment officer of Clark Capital Management Group, an investment firm in Philadelphia. “[ETFs] offer the same benefits as mutual funds, such as diversification and professional portfolio management, yet there are many reasons to invest in ETFs instead of mutual funds.”
As the name suggests, ETFs trade on stock exchanges, usually the American Stock Exchange. There are hundreds of listed ETFs, but they generally fall into one of two categories: closed-end funds and index ETFs. Closed-end ETFs tend to be actively managed by an investment adviser, meaning that the sponsoring company picks out certain stocks or bonds for the fund. They are also not generally redeemable. For example, the newly formed Nuveen Tax-Advantaged Total Return Strategy Fund invests in floating-rate loans as well as in stocks that pay low-taxed dividends.
Other closed-end ETFs might hold virtually any type of investment vehicle, from California-issued municipal bonds to stocks issued by companies in Thailand. Their performance can be excellent. The Website www.etfconnect.com reports that one of last year’s leaders, Thai Fund, returned more than 150% through November 2003.
Index ETFs track a particular index, from the Dow Jones Industrial Average to Morgan Stanley’s index of issues trading on the Tokyo Stock Issue. Unlike closed-end ETFs, shares for an index ETF can de redeemed daily. “These ETFs go by names such as iShares, SPDRs [spiders], and HOLDRS [holders],” says Clark. “They tend to be less expensive and more tax efficient than index mutual funds. ETFs trade all day long, which precludes the illegal trading practices that caused the mutual fund scandals.” Again, some index ETFs enjoyed a spectacular year in 2003 with returns as high as 104%, such as iShares’ Goldman Sachs Networking Index Fund, which holds technology stocks.
How ETFs Differ From Mutual Funds
With a mutual fund, investors buy and sell shares from and to the fund itself. Investors trade ETFs among themselves. “Some mutual funds impose redemption fees if you buy and sell the fund within, say, 90 days,” says Clark. “That’s not the case with ETFs.” However, you will incur transaction costs with ETFs (similar to making a stock trade). So if you elect to buy them, you may do better working with a low-cost discount broker.
Another benefit: “With an ETF, you’re not buying someone else’s basis. This helps them to be tax-efficient,” says Clark. To give an example, suppose you buy a small-cap index fund. The best performing stocks will grow to become mid-caps, so they won’t be eligible for that small-cap fund any