What are index shares? Well, many of you will be owning them

THE BALTIMORE SUN

At the mutual fund industry's biggest conference of the year, the biggest topic for discussion seemed to be whether anyone would own mutual funds in the future.

Shortly before the Investment Company Institute general membership meeting began this month, the Vanguard Group announced that it would soon create a family of "exchange-traded funds," commonly called index shares. As the conference closed, Barclays Global International opened a wide range of new index share issues.

Somewhere between those two moves, what became painfully obvious is that many ordinary investors will soon be considering a type of investment that most have never heard anything about.

Even those people who understand index shares - more commonly known as Spiders, Diamonds, QQQs, and more - are about to see major changes in this relatively new type of investing.

Some background:

Exchange-traded funds, in general, are investments that are built like mutual funds but that trade like stocks.

The Spider (SPDR) - named for the Standard & Poor's Depositary Receipt - is a unit investment trust on which shares are sold. You can get Spiders in many flavors, from the traditional Standard & Poor's 500 to versions covering mid-cap stocks, sector investing, and more. Diamonds are the same type of investment, modeled on the Dow Jones industrial average. QQQs (often called Cubes) are tracking stocks for the Nasdaq 100 index.

And, there are other recently created trusts that trade on the American Stock Exchange, called HOLDRs, or Holding Company Depositary Receipts. These securities are unmanaged baskets of 20 stocks, created by Merrill Lynch & Co. Inc. and covering specific industries such as biotechnology and business-to-business commerce.

In total, index shares have been a small-but-noisy market segment for a while now, attracting a lot of attention and more than $40 billion in assets.

Structurally, there are fine-line differences between all of these investments, but they have the same underlying benefits and advantages, namely:They trade like stocks.They tend to be tax-efficient, often more so than mutual funds tied to the same index.Operating costs are ultra-low, although the cost of commissions paid on purchases and sales does mitigate this advantage slightly.

Since they were first created, exchange-traded funds have been seen mostly as the realm of professional investors, big institutions, and financial advisers sophisticated enough to want or need the additional benefits over the ease of buying a traditional mutual fund.

In fact, a year ago, at the same Investment Company Institute meeting, Vanguard Chairman Jack Brennan talked about how he did not consider SPDRs much of a competitor for funds, nor much of a mainstream investment.

Ordinary investors who buy Spiders, he warned, are too likely to turn into traders, to take advantage of the easy, timely access, which runs counter to the long-term buy-and-hold nature of index investing.

Now, Vanguard is coming out with its own brand of index shares, which it calls VIPERs (for Vanguard Index Participation Equity Receipts), based on five of its index funds.

While VIPERs won't be available for a few months, investors in the Vanguard funds mimicked by the new shares actually will have the option of converting from funds to index shares without incurring any sales charges or taxes.(Brennan noted that one benefit to the firm's fund investors from VIPERs is that market-timers are more likely to move into the new product, which will help make the traditional index funds easier to manage.)

"Vanguard offering these new shares is like exchange-traded funds getting the Good Housekeeping Seal of Approval," says John Rekenthaler, Morningstar's director of research. "Vanguard is about as mainstream as it gets, which means that exchange-traded shares are now mainstream investments."

Barclays Global Investors launched the first of its own series of exchange-traded funds - which it calls iShares - May 19. (State Street Global Advisors also is in the process of expanding its exchange-traded fund offerings.)

Where Vanguard executives believe that index shares will supplement mutual funds, Barclays officials seem to believe that this is the beginning of the end for the mutual fund.

"Exchange-traded funds are really just on the precipice of becoming an enormous part of the landscape," says Barclays Chairman Patricia Dunn, who noted that similar units are the largest fund-like investment in Canada.

"The basic idea is to offer investors the broadest selection of investment vehicles at the lowest cost available, and that's a permanent idea in terms of its appeal to investors. ... They are a legitimate investment option for everyone."

At a conference in New York week before last, industry officials noted that several firms are considering creating exchange-traded funds based on actively managed mutual funds. It most likely would take two years to develop those products - and there are plenty of structural problems that will have to be overcome, because managed funds do not lend themselves so easily to this type of repackaging - but a major expansion of index shares is on the way.

"I don't think this is the death of the mutual fund as we know it, but exchange-traded funds are definitely going to have a place," says Tim Harbert, president of State Street Global Advisors. "But there will come a time when investors are deciding between funds and [index shares]."

Ultimately, many observers believe that Vanguard's entry and the mainstreaming of index shares will make for significant changes in the fund industry.

Funds could move to be priced more often and to trade at more regular intervals, an increasing possibility as the stock market moves toward round-the-clock trading.

Funds already have been moving toward being more tax-aware, meeting the desire of investors who don't want to surrender too much of their gains to Uncle Sam. Sure, exchange-traded funds are designed to be trading vehicles more than long-term investments. But most observers believe that the future has room for both investments in the portfolios of ordinary investors.

"Look at the attributes of [index shares] and see if they are a meaningful addition to the arsenal of investors," says Ed Rosenbaum, director of research at Lipper Inc. "You can talk about how wrong it is for some people to trade in and out of these things, but the sophistication of the individual investor is demanding the development of more and newer products.

"These are not right for everybody, but as they become a mainstream investment they should provoke deep thought in investors as to the role of funds in their investment portfolio. Some people will decide [index shares] are the way to go. I suspect most people will stick with funds, but the probing of which investment is right will be good for everyone."

Charles A. Jaffe is personal finance columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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