Individual investors discover hybrid securities called ETFs


Spiders and vipers and qubes - oh my. It's a jungle out there in the world of exchange-traded funds, and it's about to get more crowded.

The first ETF roared onto the market in 1993 when the American Stock Exchange created the Standard & Poor's Depository Receipts trust, or SPDR, to mirror the S&P; 500. Since then, more than 150 ETFs have been created, with about $211 billion in invested assets, according to the Investment Company Institute, an association of investment companies.

Institutional investors and hedge funds once were the largest holders of ETFs, but these days much of the new money flowing into the funds is coming from individual investors.

Here's what you need to know about ETFs:

They are hybrid investments. Think of ETFs as mutual funds that can be bought and sold throughout the day like a stock, said Daniel Culloton, fund analyst for Morningstar Inc.

ETFs mirror an existing equity index, and in some instances, a fixed-income index. The QQQQ (qubes) is tied to the Nasdaq 100 index and the DIA (diamonds) to the Dow Jones industrial average.

However, unlike an index mutual fund, the ETF may not be a carbon copy of the index it is mimicking. Some indexes, such as the Russell 2000, have so many stock components that the ETF will own a representative sample.

Unlike mutual funds, where prices are set at the end of each trading day, ETF prices can constantly change.

"ETFs represent a basket of securities, and it is priced every 15 seconds," said Victoria Klein, managing director of iShares, a division of Barclays Global Investors in San Francisco. "As underlying securities in the basket are changing values, so is the net asset value of the ETF." Barclays has 97 ETFs, making it the largest issuer.

As for buying and selling ETF shares, you'll have to go through a broker, which means you'll pay a commission. You can't go directly to the investment fund, as you could when purchasing shares of a no-load mutual fund. (There's a different set of purchasing rules for institutional investors.)

Cost structure. When you compare buying shares of an ETF to putting money into a noload mutual fund, the mutual fund is going to win in terms of cost because of the broker fee involved to get you an ETF stake.

But there are lower expense ratios - the cost you pay for operating expenses and fund management - for ETFs compared with mutual funds, and ETFs are more tax-efficient because of the low turnover in holdings.

There is no difference in the tax consequences of holding an ETF or a no-load mutual fund in a tax-sheltered retirement account. But in taxable accounts, ETFs have the advantage because they are less likely to have capital gains distributions.

If you're an investor who tinkers with your portfolio frequently, a family of no-load mutual funds would allow you to avoid the fees of buying and selling ETF shares, said Avi Nachmany, director of research for Strategic Insight, a mutual fund research firm in New York.

Returns. It's nearly a wash between mutual funds and ETFs. What makes the difference is how you plan to invest your money. Higher expense ratios for mutual funds would eat into your returns if you're making a large lump-sum investment, say $10,000. But if you're planning to sock away money on a monthly basis, those commission charges for an ETF will start to add up.

Here's a look at how costs play out for a mutual fund and an ETF, both with a 7 percent return and both tied to the S&P; 500. We're assuming a 0.18 percent expense ratio for the mutual fund and a 0.09 expense ratio and $20 brokerage commission for the ETF.

Put in a one-time, $10,000 investment, and after 10 years your ETF costs would be $167 while the mutual fund would run nearly $255.

But the mutual fund comes out ahead if you're like many investors and save $200 a month for 10 years - a cost of $275 compared with $2,654 for the ETF, thanks to the monthly commission.

Lorene Yue is a Your Money staff writer.

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