Can Investors Live Without ETF Shares?

Physician's Money Digest, March15 2005, Volume 12, Issue 5

People often ask me, "Should I buyexchange-traded funds (ETFs)?"Like many other profound questions,this one can be answered with adefinitive "maybe."There are two thingsthat you really need to know about ETFs.First, ETFs are just index funds in a differentpackaging. Second, if Wall Streetinvented ETFs, it must have done somostly for its own benefit, not yours. Sobe skeptical about the promotions.

ETFs Are Index Funds

The mutual funds you are used to buyingare technically called open-end mutualfunds. To invest money in such a fund,you send your money to the fund companyand they issue new shares to you at theend-of-day net asset value (NAV). Whenyou redeem shares, the fund companybuys them back from you at the NAV andeffectively retires the shares. You alwaysdeal directly with the fund company andyou can buy and sell only once a day at theNAV at that time. If you buy an open-endindex fund, your money is then invested inthe shares that comprise the index, in thesame proportion.

All ETFs are also index funds, and whenyou buy an ETF your money gets investedthe same way. So in terms of the stocks orbonds you're investing in, there is no differencebetween an open-end fund andan ETF based on the same index.

The key difference, however, is thatbecause of the way they are structured,ETFs are traded on stock exchanges likestocks. You can buy ETFs any time duringthe trading day, generally, thoughnot always, at a price close to the NAVat that time. As with individual stocks,you will have to go through a brokerand pay commissions for both buyingand selling. Similarly, you buy theshares in an ETF from and sell them toanother investor or market maker, notthe fund company.

Know the Advantages

Wall Street people will mention at leastthree potential advantages of ETFs vis-à-vistraditional mutual funds. First, ETFs let youget into and out of the market at any time.This is true, but to me, this can be a disadvantagealso, because it is likely to encouragetrading. (Could that be one motivationbehind the invention of ETFs?) Ifyou're planning to hold an index fund forthe next 5 or 10 years, do you have to getin at 11:15 AM on a particular day?

Second, most ETFs have lowerexpense ratios than equivalent mutualfunds. But there are those commissions,which can be hefty at many brokeragehouses. If you want to do dollar-costaveraging or invest a small amount ofmoney, a low-cost, open-end mutualfund may be a better choice.

Third, ETFs may be somewhat moretax-efficient. This is a complex issue. Formore on this and ETFs in general, visitthe iShares site (www.ishares.com),which is the major brand name in ETFs.There are other brand names such asVIPERS and HOLDERS. The differencesamong ETF brands are minor. What youshould focus on is which market index anETF is based on.

Heed One Caveat

Many people buy ETFs thinking that ina market panic they will be able to get outquickly at any time of the day instead ofgetting a lower end-of-day price they mayget for an open-end mutual fund. I wouldnot count on that. If you sell your ETF in ahurry, you will probably get a much lowerprice than that of the underlying index.

Bottom line:

Now that you understand ETFs andtheir advantages and limitations, you candecide for yourself if you should invest inindexes through ETFs or traditional open-endfunds. You can live a perfectlyhappy and fulfilling life and be asuccessful long-term investor without everbuying a single ETF.

author of

The Only Proven Road to

Investment Success (John Wiley;

2001) and Financial Modeling

Using Excel and VBA (John

Wiley; 2004), currently teaches

finance at the Fordham University Graduate

School of Business and consults with individuals

on financial planning and investment management.

He welcomes questions or comments at

chandansen@aol.com.

Chandan Sengupta,