ETFs wave of the future

Praised for their low cost, tax efficiency and transparency, exchange-traded funds are considered the wave of the future by many financial professionals, but you should make sure they’re right for you before making the switch from traditional index funds.

ETFs are no longer market oddities with funny names, like Spiders, Diamonds and Qubes. Through the second half of the year, ETF assets had swollen to $242.66 billion, according to the Investment Company Institute, a 36 percent increase over June 2004. The number of offerings is on the rise, as well, as Wall Street rushes to take advantage of growing demand for these index-tracking baskets of stock. There are now almost 200 ETFs to choose from, which opens up a world of choices to investors who are increasingly seeing the benefits of indexing.

“There is a very good trend happening in the marketplace, where people are recognizing it’s an admirable goal to earn the market return. And by definition, that’s what ETFs allow you to do,” said Robert R. Johnson, managing director of the CFA program division at the CFA Institute, a nonprofit group that certifies financial analysts. “For smaller retail investors, who perhaps don’t have the requisite asset base to have professional help … investing in a broad index ETF is a very sound strategy.”

The broadest ones are the most popular, accounting for nearly a third of all ETF assets. The very first ETF, issued in 1993, is still the biggest; it’s the tracking stock of the Standard & Poor’s 500 (SPY) and is now part of a series of ETF SPDRs, which stands for Standard & Poor’s Depositary Receipts. The S&P 500 ETF holds an estimated $49 billion.

Diamonds (DIA), launched in 1998, is another investor favorite, following the 30 stocks of the Dow Jones industrial average. It has net assets of more than $7.5 billion. The most heavily traded ETF is the QQQQ, or Qubes, (QQQ), which tracks 100 large-cap issues on the technology-dominated Nasdaq Stock Market. First issued in 1999, the Qubes holds $19.83 billion in net assets.

Newer arrivals tend to be more specialized in nature, such as three funds launched this month by iShares: the Russell Microcap index fund (IWC) — the first ETF to track the market’s tiniest stocks — and two pegged to the Europe, Australia, and Far East Index from Morgan Stanley Capital International, one to track value stocks (EFV) and the other to track growth (EFG). This reflects a trend among active investors to drill down into very narrow market segments, which highlights an important point: All ETFs do not offer the diversity associated with broad index funds.

Still, the ability to invest in such tightly focused areas underscores the usefulness of ETFs when it comes to precise asset allocations, a trait that makes them attractive to money managers such as Sean Clark of Clark Capital Management in Philadelphia. In many cases, the only way to invest in a niche is through a traditional actively managed mutual fund, which usually comes with steep expenses and none of the trading flexibility of ETFs, Clark said.

“I’m such a big fan of ETFs, if I have the opportunity to use an ETF or a traditional index fund, I’d probably go with the ETF,” said Clark, who has been building portfolios using ETFs for more than five years.

The most important factor for Clark is that ETFs trade all day, like stocks, meaning you can buy or sell them in real time, unlike traditional mutual funds, which are priced once daily, at the market close.