Blocks of stocks that favor fast traders

With a bit of pomp and ceremony, two new "exchange-traded funds" (ETFs) were listed last Tuesday on the American Stock Exchange.

They brought the total number of ETFs, a hot, relatively new product in the financial world, to 72. The total assets and average trading volume of these funds have doubled each year for the past five years as the number of funds and the buzz around them have multiplied.

That's great for Wall Street. It thrives on the commissions and fees generated by bustling investment products.

But are ETFs a good idea for the ordinary, individual investor?

Opinions vary.

First, what are ETFs? They are a pool of corporate stocks that resemble index funds, the familiar mutual funds that mimic a stock-market index, such as the Standard & Poor's 500 Index or the narrower Dow Jones Industrial Average. If the S&P 500 index jumps during the day, the shares of the huge Vanguard 500 Index Fund, for example, will similarly rise in value.

ETFs differ in that they are structured like an individual corporate stock. They can be traded at any time during trading hours on the New York-based American Stock Exchange (ASE). Their price during the day will vary somewhat according to the demand and supply for the specific ETF shares. The seller gets the price the buyer is willing to pay.

In the case of a regular open-end mutual fund, shares are bought from or sold to the fund at the price that reflects the net asset value of the shares in that fund's portfolio at the end of the trading day. Though an investor may call in a sale early in the day, the price he or she gets would reflect how the market closed on that day - up or down.

So far, ETF shares have been traded primarily by institutions, investment advisers, and sophisticated traders.

"The professional financial community is taking advantage of them," says Robert Rendine, a spokesman for the ASE where all ETFs are traded.

ETFs can be bought on margin (using borrowed money) or shorted (using borrowed shares), like a stock. If an investor believes the market represented in an index is going to tumble, such a "short" of the corresponding ETF could be profitable if the market did plunge.

Some high-tech executives who hold many shares and stock options in their firm, hedge against a drop in the value of these investments by buying an appropriate ETF.

But some sponsors of these funds would like to broaden the ETF market to individual, less-sophisticated investors. Altogether, the 72 ETFs have assets of about $55 billion, about the same as the 18th-largest mutual-fund group.

The two new ETFs, managed by State Street Global Investors in Boston, are tied to two popular stock lists that might appeal to individuals - the Fortune 500 and Fortune e-50 (Internet stocks).

"For certain people, an index fund is a better option," says Gregory Ehret, principal at State Street. "For others, ETF shares are better."

Vanguard Group in Valley Forge, Pa., is seeking approval of the Securities and Exchange Commission in Washington for five ETFs. These are based on its own index funds, including the 500 Fund.

"We see them as trading vehicles," says Brian Mattes, a Vanguard principal. "For the long-term holder, they are ill-suited because of their cost."

ETF promoters usually cite low cost as an advantage. The annual expenses for an ETF are lower than for most mutual funds, though not necessarily for some large index funds.

Costs are low because the ETF manager doesn't alter the fund portfolio often except for rebalancing should the stocks in the index it represents change. Though this process can be complex, the ETF doesn't pay a host of expensive stock analysts to help in the selection of stocks as does an actively managed mutual fund.

For instance, the annual fee for the oldest ETF, the SPDR, amounts to just 12 basis points, or 0.12 percent of the assets. (Based on the S&P 500, the "spider" was created by State Street and the American Stock Exchange in 1993.) Other ETFs may charge as much half a percentage point.

The expense ratio of most mutual funds is 1 percent of assets or more. A large index fund, such as the Vanguard 500, may charge as little as 0.18 percent.

But Mr. Mattes points to other expenses involved in buying an ETF. The buyer or seller must pay a brokerage fee. The brokerage account, if not used much, may be subject to an annual fee.

"ETFs are not as inexpensive as they are made out to be," he says.

In general, the price during the day of an ETF share runs close to the net asset value of stocks in its portfolio. If it strays enough, an arbitrager at a brokerage house may step into the market to take advantage of the spread, thereby helping close it.

Say the ETF was a "Diamond," which is based on the Dow Jones Industrial Average of 30 stocks. If the Diamond was a bargain, the broker could buy it and sell the stocks within that average for a profit.

"Specialists" on the exchange floor also intervene in the market to protect the price.

Nonetheless, the discount or premium on an ETF share can reach 50 basis points, notes Mattes. That can hurt an investor.

And he wonders what will happen to ETF shares should the market plunge drastically as it did on Oct. 19, 1987.

But ETF discounts are in no way as large as the 5 to 15 percent discounts that can come with closed-end mutual funds, which also have fixed portfolios of investments.

So far, all ETFs have "passive" portfolios. The American Stock Exchange is exploring the possibility of creating an actively managed ETF not based on an index. But government approval could be more than a year away.

One problem is "transparency."

Currently, an investor can more or less know the portfolios and values of ETFs by following the market indexes they are based upon.

But knowing the portfolio of an actively managed fund is difficult. Managers of these funds don't want the market to know the stocks they buy or sell at any moment. Other investors can leap into the market to exploit such knowledge. Regular mutual funds must publish their portfolios only twice a year.

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ETFs -- A good investment?

Investors should weigh the following pros and cons before putting money into an exchange-traded fund:

-- Annual management fees can be low compared to a regular mutual fund. But if the ETF is traded frequently, brokerage fees can add up, wiping out any cost savings.

-- ETF shares can be bought or sold anytime during the trading day at the price prevailing at that point on the American Stock Exchange. That's an advantage for the investor attempting to time the ups and downs of the market. To a long-term investor, this has less merit.

-- An investor can buy an ETF on margin, using borrowed money. This leverage increases the possibility of making - or losing money. An ETF can also be shorted, using borrowed shares. This can be useful as a hedge against other investments.

(c) Copyright 2000. The Christian Science Publishing Society