Employ Prudence when Selecting an ETF

Physician's Money Digest, May 15 2004, Volume 11, Issue 9

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Exchange-traded funds (ETFs),which track stock and bond indexesand trade on stock exchanges,have experienced tremendous growth.According to a report,assets held in ETFs more than doubled in2003 to $160 billion.

Now, in the wake of the mutual fundscandal, even more individual investorsare making ETFs a part of their portfolios.Not surprisingly, fund companies areresponding to the increased demand. Forexample, Vanguard Group, which introducedtwo ETFs several years ago,launched 14 Vanguard Index ParticipationEquity Receipts earlier this year, and hassix more ETFs in the works.

ETF Attraction

The appeal of ETFs is apparent. Theyare cheaper, easier to trade, and usuallymore tax efficient than mutual funds.Perhaps most appealing is that they provideinvestors with the ability to tradethroughout the day and use stop ordersand limit orders, something not possiblewith mutual funds.

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However, William Bernstein, MD, thenoted author, money manager, and neurologist,tells that the reasonfor the increased interest in ETFs ishuman nature. "People like associatingthemselves with what's hot," Dr. Bernsteinexplains. "And right now, ETFs are thebuzz." This is just another way ofsaying that Dr. Bernstein and others likehim are not so awestruck by ETFs.

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It's true that ETFs are inexpensive toown, relatively speaking. The article points out that the typicalequity ETF costs just 0.4% annually, comparedwith 1.4% for the average stockmutual fund. However, to buy or sell anETF you must pay a commission. That commissioncan range from $5 to $30 online,and more at a full-service broker.

What this means is that an investorwho employs a system such as dollar-costaveraging, where each month $250 investmentsare being made, is losing 12%of their investment with every purchase ifcommissions are $30. For someone makingfrequent, systematic investments, ETFsmight not be the way to go.

Assortment of ETFs

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Due to their increasing popularity,there is a wide range of ETFs to choosefrom. According to the article, more than 85 ETFs track domesticstock indexes, and at least 40 mirrorinternational equity indexes. Some ofthe more popular ETFs include DiamondsTrust Series I, which tracks theDow Jones Industrial Average, andQubes, which mimics the Nasdaq-100Index Tracking Stock.

One of the key fundamentals of successfulinvesting is diversification, andinvesting in an ETF doesn't automaticallyprovide that diversification. For example,the article points out that nearly 42% ofQubes' assets are made up of 10 companies,including Microsoft, Intel, and CiscoSystems. That might be a little too muchtechnology for your taste, so understandthe portfolio construction of the ETFyou're choosing.

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One additional concern about ETFs isliquidity. The article points out thatproblems can occur, particularly foractive traders who try to trade less popularETFs. Donald Cassidy, a senior researchanalyst at Lipper Inc, tells "The first fund of its kind tocome out typically attracts the dollarsand keeps the trading volume."

With that in mind, despite the proliferationof new ETFs hitting the market,you might want to stick with the moreseasoned ones as your investment vehicleof choice.