These offerings have several advantages over traditional mutual funds.
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By Christopher Traulsen, CFA | 08-24-00 | 06:00 AM | Email Article

Unless you've been living in a cave for the past few months, you've probably heard the buzz about exchange-traded funds (ETFs). They've been around for years, but as giant asset managers such as Barclays Global Investors and Merrill Lynch have rolled out scores of new offerings in recent months, and Vanguard readies its own version, called VIPERs, they've become the hot topic du jour.

Christopher Traulsen joined Morningstar in 1997 and is currently Director of Global Manager Research EMEA responsible for Morningstar Analyst Rating™ assignments globally. He leads four global asset class teams, overseeing qualitative ratings and global thought leadership.

Here, and in Part II of this guide to ETFs, we'll give you an overview of the world of ETFs, including how they differ from regular mutual funds, what their advantages and disadvantages are, and how to ascertain whether or not they might be appropriate for you. Read on, and learn more about this growing area of investment.

What are Exchange-Traded Funds?
At the most basic level, ETFs are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange (all available offerings currently trade on the American Stock Exchange). Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin--in brief, anything you might do with a stock, you can do with an ETF.

Most also charge lower annual expenses than even the least costly index mutual funds. However, as with stocks, you must pay a commission to buy and sell ETF shares, which can be a significant drawback for those who trade frequently or invest regular sums of money.

There are a number of different ETFs on the market currently, including Qubes, SPDRs, sector SPDRs, MidCap SPDRs, HOLDRs, iShares, and Diamonds. All of them are passively managed, tracking a wide variety of sector-specific, country-specific, and broad-market indexes.

Their passive nature is a necessity: As we'll explain later, the funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. Active managers, however, are loath to disclose such information more frequently than the SEC requires (which currently is twice a year).

How Do ETFs Work?
Although ETFs are more flexible than mutual funds in many respects, and they can be traded on an exchange throughout the day, their shares cannot be bought from or sold back to the fund company like regular mutual funds. With the exception of Merrill Lynch's HOLDRs, investors can only buy or redeem shares directly from the fund company in 50,000-share blocks, and even then, the funds require in-kind transactions--that is, you don't get cash when you redeem your shares, you get the underlying stocks. In practice, this means that only institutions and the very wealthy can afford to deal directly with the fund companies. The rest of us have to go through a broker to buy and sell shares.

Unlike regular mutual funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, the market price of an ETF is determined by forces of supply and demand for the ETF shares. To a large extent, the supply and demand for ETF shares is driven by the underlying values of their portfolios, but other factors can and do affect their market prices. As a result, the potential exists for ETFs to trade at prices above or below the value of their underlying portfolios.

However, by permitting large investors to buy or redeem shares in-kind, the fund companies behind ETFs have created a mechanism that should, in theory, help prevent sustained discounts or premiums from opening up.

If an ETF traded at a discount to its net asset value, institutional investors could assemble 50,000-share blocks in the open market at the discounted price, redeem them for the underlying stocks, and sell those stocks at a profit. The actual transaction isn't quite that simple, but the idea is the same: The arbitrage opportunity would generate sufficient demand for the discounted ETF shares to close the gap between their market price and the net asset value of the underlying portfolio.

Are ETFs Right for You?
ETFs have several clear advantages over traditional mutual funds. Most notably, their annual expense ratios are considerably lower. They're also more tax-efficient, and they can be traded throughout the day. Nevertheless, they aren't suitable for everyone. In Part II of this guide to ETFs, we'll take a detailed look at their advantages and disadvantages to help you determine what role, if any, they should play in your portfolio.

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Christopher Traulsen, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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