ETFs Offer Flexible Downside Protection

Physician's Money Digest, May 15 2003, Volume 10, Issue 9

The emergence of a newbreed of mutual funds, exchange-traded funds (ETFs),is getting the attention of investors.Despite the sliding stock market,ETFs have actually enjoyed a steadyexpansion of fund assets throughoutthe past 3 years.

New York Times

ETFs track stock and bond indexesand trade on stock exchanges.What makes them different fromtraditional mutual funds, accordingto an article in the , isthe investor's ability to tradethroughout the day and to use stop-lossorders and other trading collars.Such downside protection iscomforting to many investors.

CONTINUED GROWTH

ETFs have grown from beingused mainly by professionals toattracting an increasing number ofindividual investors. The tradingflexibility of ETFs is particularlyappealing to traders who areuncomfortable with their inabilityto trade a traditional mutual fundexcept at the price set at the end ofeach trading day.

For years, the funds were allbased on stock indexes. Recently,however, the asset management firmsBarclays' Global Investors and ETFAdvisors opened the first fixed-incomeETFs that are based onindexes of US Treasury and corporatebonds. Lee T. Kranefuss, chiefexecutive of Barclays' business forindividual investors, predicts thatfirms like his will eventually marketa full array of bond offerings tied tomunicipal bonds, high-yield or junkdebt, and even secured mortgages.Other asset managers are planningfor a new generation of ETFs,which would be actively managedby stock pickers rather than mathematicallymirroring the compositionof a stock or bond index.

PROS AND CONS

ETFs can usually be run with asmaller overhead than the averageindex-oriented mutual fund becauseof a capitalization structure in whichinstitutions create and redeem blocksof shares in ETFs. For example, theVanguard 500 Index fund, the largestindex mutual fund in the nation,charges 0.18% a year. But Barclays'iShares S&P 500, an ETF, chargesonly 0.0945%.

ETFs are more attractive thanclosed-end funds, which also allowinvestors to trade throughout theday. With closed-end funds, a setnumber of shares are sold to thepublic. When demand for thoseshares declines, the funds can tradeat a substantial discount to theirunderlying asset value. In the open-endedcapitalization structure ofETFs, however, institutions createor redeem shares depending ondemand by investors. Specialistfirms match the price of the fundsto their net asset value, preventingthe discounts that are often seenwith closed-end funds.

A major disadvantage of ETFs isthat they can be bought only throughbrokers whose commissions gettacked onto the cost of the investment.Thus, if you want to purchaseshares of a fund monthly or quarterlywith a fixed amount of money (ie,dollar-cost averaging), it would bebest to use a no-load index mutualfund.