The ABCs of ETFs

By Daniel Kadlec

About 10 years ago, I was asked to draw up a list of predictions for the mutual-fund industry. O.K., so I was wrong about money-manager trading cards, and Peter Lynch didn't run for President. But I got this right: entire stock portfolios now change hands at the click of a mouse. I stand by my assertion that one day most mutual funds will do the same. They'll be priced throughout the day--not merely at the close--and traders will shoot in and out of them as they would an overhyped IPO.

It's all part of the growing importance of individual investors, who want easy, flexible, low-cost diversification. For now, all the action in tradable, pre-fab stock portfolios is with index funds, which are more readily priced tick by tick because they hold the same stocks a long time. Eventually, though, actively managed mutual funds will be continuously priced--and actively traded.

This trend bothers some, who are worried that it encourages short-term thinking. But it's only right that fund investors choose their entry and exit points on a real-time basis. The bonus here is that for the first time investors have a real alternative to traditional mutual funds, and that will help keep a lid on mutual-fund fees.

The granddaddy of these so-called exchange-traded funds (ETFs) are SPDRS (called Spiders). Around since 1993, this security mimics the Standard & Poor's 500. Each share represents a fraction of a share of 500 companies. Your investment moves in lockstep with that well-known benchmark. Other popular ETFs include QQQs, known as Cubes and based on the NASDAQ 100, and Diamonds, based on the Dow.

The expense ratios on ETFs are generally--but not always--lower than those on comparable funds at, say, Vanguard or Fidelity. But you pay a commission to get in and out. So while ETFs make it easy to day-trade the whole market around Greenspan's latest remarks, they also make it expensive to invest small amounts.

In the past year, a new breed of ETF, called iShares, has taken wing. Formerly known as WEBs and primarily built around foreign stock indexes, it was dusted off by Barclays Global Investors this year, renamed and expanded to include specific U.S. sectors such as health care, energy and real estate.

In all, there are now 60 ETFs with a market value of $46 billion--triple the assets in these funds just two years ago. Vanguard has promised an array of competing ETFs, to be called Vipers; and Merrill Lynch has entered the tradable-funds sweepstakes with HOLDRs (Holders). Again, you pay a sales commission, but the management fee is minimal, and waived altogether if not covered by dividends paid by companies in the portfolio. The basic HOLDR consists of 20 stocks targeting, say, the Internet, biotech or banking industry.

Both Holders and ETFs are tax efficient. You decide when to sell so you'll never get smacked with a surprise capital gain. With Holders, you also have the option of weeding out losers and taking a deduction while keeping the rest. For steady, small-dollar investing, you still can't beat common mutual funds, especially those in a 401(k) plan. But exchange-listed, tradable stock funds aren't just another fee-laden profit center for Wall Street. For many investors, their low cost and tax flexibility make them a useful alternative.

See time.com/personal for more on ETFs. E-mail Dan at [email protected] See him Tuesday on CNNfn at 12:20 p.m. E.T.