THINKING ABOUT investing in Spiders? What about Diamonds?
Don't worry. We aren't suggesting you start trading furry, eight-legged critters. (Or gems for that matter.) We're talking about exchange-traded funds (ETFs), a relatively new breed of mutual funds that, among other things, come with some pretty unusual names.
Most ETFs are open-end mutual funds — but with an important difference: They trade like stocks. This means they price continuously throughout the trading day, not just at the market close, as is the case with most funds. This characteristic has made them popular during the volatile bear market, allowing investors to move in and out quickly. (In fact, in 2002, ETFs experienced substantial gains in assets, while many investors fled traditional equity-based mutual funds.) ETFs also have some distinct advantages for long-term investors — namely low costs and high tax efficiency.
Right now, the most popular ETFs follow indexes, which makes them very similar to index funds. Standard & Poor's Depositary Receipts (SPY), or Spiders, track the S&P 500 index; Diamonds (DIA) follow the Dow Jones Industrial Average; and the Nasdaq-100 Trust (QQQ), or Cubes, benchmark the Nasdaq 100 index. And they usually do it at a lower cost than even the most budget-conscious index funds. Case in point: SPDRs cost only 0.12% a year, while the ultracheap Vanguard 500 Index fund is priced at 0.18%.
Tax efficiency is another key quality of ETFs. ETF providers, unlike regular fund managers, aren't forced to sell the fund's holdings when a significant number of shareholders redeem their shares. That's not to say an ETF has never handed out a tax hit, although so far this group has done so less frequently than typical mutual funds.
The biggest drawback to ETFs is that they must be purchased through a broker, which means you'll have to pay a commission each time you trade the shares. If you rely on dollar-cost averaging to invest in funds, ETFs will lead you to a hefty brokerage bill.
Currently there are 116 ETFs available, including those based on specific stock sectors, such as financials, technology and utilities. Also available: ETFs that track the indexes of specific countries ranging from Australia to Taiwan. And in 2002, fixed-income ETFs made their U.S. debut. Looking ahead, more bond ETFs are in the works, as are actively managed ETFs.
Despite their growing popularity, ETFs still aren't owned by a broad spectrum of individual investors. But we expect they'll gain popularity as word of their advantages gets out.
