Fair Exchange?

In nearly 10 years, demand for exchange traded funds has grown from nearly nothing to three-quarters of a trillion dollars a year. Impressive? Of course. Still, some financial services executives see ETFs as a disappointment.

Consider this: From the 1993 rollout of ETFs through the rest of the decade, sales doubled almost every year, climbing to $750 billion. “It's true ETFs have had some good growth,” says an executive with a prominent ETF producer. Yet, he adds, “There is this feeling that ETFs haven't done well enough.”

With ETFs, you can expose your client to nearly every possible industry in nearly every corner of the world. But most advisors and investors seem interested in just a handful of the funds. Four ETFs account for more than two-thirds of all ETF trading: S&P 500 Depository Receipts (SPY), Nasdaq 100 Index (QQQ), MidCap SPDRs (MDY) and Dow Diamonds (DIA).

And that's a shame. ETFs offer relatively inexpensive ways to get exposure to a region, industry or sector without the burden of having to pick individual stocks. Besides having low expense ratios, they can be relatively tax-efficient since the portfolios don't turn over much.

Because they trade on an exchange (just like stocks), ETFs don't trigger tax consequences when other investors sell shares. That means clients aren't saddled with large capital gains distributions. (About 60 percent of ETFs had capital gains in 1999 — the last strong year for the markets — though most were quite small when compared with traditional mutual funds.)

There is now a wide range of ETFs to choose from — from REITs to banks to energy firms — representing just about every corner of the world. The John Nuveen Co. is even launching fixed income ETFs. “There is a much wider range of ETFs than there is open index funds,” says Rick Roberts with Deutsche Bank Asset Management. He also likes to short ETFs — something you can't do with regular mutual or index funds.

In recent quarters, ETFs also have become more popular for investors seeking style diversification. For example, an investor that holds a group of growth stocks may look to value-oriented ETFs for diversity. Another benefit: Investors looking to get around wash-sale rules can buy a corresponding ETF, park the money there for 31 days, and still get similar industry exposure to the stock sold.

But investors who thought they could profitably buy and sell ETFs at a fast clip have discovered how quickly brokerage commissions eat away at profits. So it makes sense to devote a reasonable chunk of money to an ETF to amortize the expense of those brokerage fees. Roberts considers $10,000 to be the appropriate initial investment. For clients looking to purchase ETFs by dollar-cost averaging, transaction fees can be a problem; for these folks, traditional index funds make more sense.

In addition, ETFs come with those annoying bid-ask spreads, meaning there will always be a small difference in the price that you can buy and sell an ETF. Therefore, many have concluded that ETFs are only suitable for a longer time frame.

Spreading the Word

But industry executives acknowledge that many investors remain in the dark about ETFs. “I still don't think that they're broadly understood,” says John Jacobs, senior vice president of financial products at Nasdaq. That helps explain why ETFs have been predominantly used by institutions until now. To bring in more retail investors, Jacobs is planning a marketing blitz in coming months to make ETFs a household name. “It's our job to get the word out there,” he says, adding that the PR effort will coincide with the launch of new types of ETFs.

Jacobs thinks the imminent release of a “socially responsible” ETF could help to bring in additional investors. Later this year, you can look for bond and, perhaps, actively managed ETFs as well. Jacobs thinks those products should entice more financial advisors to give ETFs a closer look.

Some brokers already are. Prudential Securities senior vice president Carolann Brown, for example, is using ETFs to provide portfolio insurance for her clients. She sells covered calls on ETFs to hedge against sector risk when her clients have a large exposure to a certain stock. And her clients benefit from the little extra income that covered calls bring in.

Brown also likes that ETFs trade like stocks, enabling her to place stop-loss limits if the market turns against her. “I've started to use ETFs a lot more for my clients recently, since they're such a big help in bad markets,” she says. Traditional mutual funds and index funds “just don't have that kind of flexibility,” she says. Brown is partial to Barclays' iShares (www.ishares.com) “since they have a good bit of liquidity behind them.” Barclays now offers more than 70 ETFs, and plans to add another dozen within the next year.

Chris Most, a financial planner with US Bancorp Piper Jaffray, is less enamored. “My clients' goals are often more specific,” he says, adding that, “I still prefer to select specific stocks that are most appropriate for the long haul.” Most clients that like to trade more actively have been the only ones to use ETFs, “and they typically stick with QQQ's (Nasdaq 100 ETF).”

Assessing your clients' suitability for ETFs is the first step. Explaining the benefits — and costs — of the funds will help them to buy in to their relative merits. For long-term investors, ETFs can provide a low-cost avenue to broadly diversified portfolios.

For more information on ETFs, check out indexfunds.com, and click on the ETF Zone link.