Some say exchange traded index funds will change the mutual fund business completely, others say they will simply make the industry more competitive. The fact of the matter is that these new products are becoming increasingly popular and look like they are here to stay.

First, let's define our terms. As their names lead one to believe, exchange traded funds trade like typical stocks on the Amex-Nasdaq. Some products currently available have catchy names such as Spiders, WEBS and Qubes. Investors can buy, sell and even short them meaning they can be sold throughout each trading day paying typical brokerage commissions.

Since the funds track indices, these securities are cheaper than actively managed stock funds. These products are also praised because of their tax efficiency as they tend not to make taxable distributions to shareholders.

So what's the brouhaha? Herb Blank, president of QED International Association, a consulting firm in New York, explained that ETFs are becoming popular because they are less expensive than most mutual funds so there are fewer tax consequences. In addition, they are convenient and flexible for the investor.

Barclays Global Investors, the world's largest indexing firm, is betting that its line of exchange-traded index funds will take off. The firm filed paperwork last year to launch more than 50 of these products, and the first cluster has already hit the market. Investors can also expect to see more products from existing players such as State Street Bank & Trust and Merrill Lynch.

"Slowly but surely they will have an impact on the mutual fund industry. Customers are throwing them in the faces of fund companies," Blank said. "Most fund families are researching how to launch such funds and if they will be effective. It is still in an embryonic stage."

Blank expects actively managed ETFs to be introduced into the marketplace by 2005. "I think it leaves mutual fund companies in the cross road. I don't think active management and exchange traded are mutually exclusive."

Tom Taggart, a spokesperson for Barclays Global Investors said, "The industry is looking for the next best thing. Mutual funds have been great but they can be improved upon."

There are currently 30 ETFs on the market, 17 of which Barclays manages. These funds have attracted $25-30 billion with little or no promotion, Taggart said. "We will be introducing more funds in the first half of the year, all of which will be index-based."

Marrying funds and stocks might be more complicated when it comes to retirement. 401(k)s play a large role within the mutual fund industry and may be more complicated to apply ETFs. Taggart said, "We will find a way into the 401(k) market. Portfolio transparency might be an issue. The advantage of an ETF is that you can see what you own every minute of every day."

Exchange traded funds will increase in popularity, according to Taggart. "Mutual funds are not going away but ETFs are for people who want added flexibility. Advisors are very bullish on the concept because the overall interest in indexing is growing. Advisors also like added flexibility where the product acts like a stock. They like the real time pricing because they know where things stand during the day."

Robert Levitt, principal of Levitt Novakoff & Company, an investment advisory firm located in Boca Raton, FA, with about $130 million in assets said that he has started using exchange traded funds as a major part of his portfolios.

"I would say they will have a big influence. We currently use some of them and will use more of them in the future. They are inexpensive and tax efficient. Although they are presently very simple to use, they could become more complicated to use as the products themselves become more complicated," Levitt said.

Right now the limited selection is all that is holding this product segment back, according to Levitt, "but it will evolve. One of the real benefits for distributors will occur when State Street is forced to reduce the cost because of Barclays. That's a win win for us."

Not all investment advisors are as bullish on exchange traded funds. Bruce Katz, director of the capital management group division Avatar Associates, an advisory firm located in New York, with about $3 billion in assets said, "We don't really use them at this point. We find it easier to use an S&P 500 fund. When we are putting together a mutual fund portfolio it's good to have the funds priced at the same time. ETFs haven't reached the general masses yet. They will be much more viable in the future."

Katz said he welcomes the flexibility of exchange traded funds but he does not see the great tax advantages touted by some in the industry. "The tax advantage for me, compared to distributions from an S&P 500 index, is minimal. The difference between an ETF and Vanguard's S&P 500 was just a few pennies. By using the ETFs, investors can get in and out many times in the day and it could end up costing more [than mutual funds]."

The real advantages of exchange traded funds compared to mutual funds are the redemption fees according to James Pritchard, ceo of Pritchard Investment Management, a Durango, CO-based advisory firm with $50 million in assets.

"If I have money that I need to put to work in the middle of the day or the markets are getting crunched during the day, being able to trade in the middle of the day can make a difference. Some index funds charge fees for redemptions. Clients do not want to see 0.50% fee on a trade. You won't have to pay that with the ETFs."

The consensus from the industry is that mutual funds are not going anywhere any time soon but ETFs will definitely be competition. "They are here to stay," Katz said, "and the mutual fund industry is not going to become obsolete because of this. As more people use these products, it may make fund companies more aware of competition, but in the end, the competition is positive and will only benefit the investor."

 

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