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Independent Investor: Index Funds Spreading FastBy Bill Schmick
iBerkshires Columnist
08:05PM / Wednesday, March 05, 2008
 | | Bill Schmick |
Last year, the three most actively traded securities in America were not stocks. They were exchange-traded funds commonly referred to as ETFs and they are taking the investment world by storm.
Right now, there are about 564 ETFs (versus 51 two years ago) worth almost $500 billion. The first ETF was launched in 1993. It was a straightforward index fund, which tracked the S&P 500 called the "Spider," standing for SPDR (Standard and Poor's Depository Receipts).
Today the SPDR's volume tops $10 billion a day – making it more liquid than any stock in the world. Many investors believe ETFs are the workingman's answer to successful investing in the stock and bond markets worldwide.
I tend to agree. So what is an exchange-traded fund? First and foremost, ETFs are index funds, which mean they invest in a set number of stocks, bonds, currencies or commodities that mimic whatever index they have targeted. Once established they don't change so an investor who buys a share gets the same return as the underlying index.
Some of them model existing indexes like the Dow Jones Industrial Average, one of America's most popular indexes, the Standard & Poor's 500, the Nasdaq 100 or a particular sector like health care or technologies. Others create new indexes in areas such as clean energy, or water resources or nuclear power that are comprised of stocks in companies involved in nuclear power, wind power, water resources or other forms of green power.
Some of the newer ETFs try to create funds that claim to out-index the indexes but the jury is still out on that.
Functionally, exchange-traded funds are a cross between a stock and a closed-end mutual fund. Like stocks, you pay a commission per share and they trade all day so you can get in and out when you want, unlike mutual funds, which trade just once a day after the markets close.
They resemble closed-end funds because once the fund manager initially purchases the securities they rarely change. ETFs are far more tax efficient as well since once the fund is established there is almost no need to buy or sell the securities in the underlying index. In contrast, active mutual fund managers are always trading stocks, bonds, etc., in their mutual funds. That's how they try to provide their investors high returns.
The average fund manager sells 85 percent of the securities in his portfolio every year (while the turnover in an ETF is just 6 percent). But every time they buy or sell a security the investor is handed a capital gain or loss for the year and those gains are taxable. It doesn't matter whether or not the investor continues to hold the mutual fund itself. A whopping 79 percent of all mutual funds distributed taxable capital gains to their investors last year.
All that trading activity and what goes on around it costs money. An active fund manager charges you a stiff fee for that effort (average fees are about 1.5 percent of assets) while an ETF manager has very little to do because the securities in her index do not change. The result is that most ETFs charge fees that are less than one half of one percent.
In the game of investment performance, lower fees and lower taxes can add up to substantial outperformance. Over the life of an average retirement savings account, even a half-point difference in fees or taxes could mean many thousands of dollars in extra return. Exchange-traded funds have also opened up vast new areas of investment to the little guy as well.
Currencies, commodities, international stocks, an array of bond choices, private equity funds and international real estate are just a few of the cost effective, liquid offerings that are blossoming in the ETF market. Statistics indicate that over time 75 percent of active mutual fund managers fail to outperform the markets.
In this case, the best bet is to simply buy a group of index ETF funds, save on fees and taxes and you'll do as well as most of the pros.
Bill Schmick is a licensed investment adviser representative and portfolio strategist with Berkshire-based Dion Money Management, managing over $800 million for middle class Americans from coast to coast. Direct your inquiries to Bill at 1-877-850-7942, Ext. 146 (toll free), or e-mail him at wschmick@dionmm.com. You can also visit www.afewdollarsmore.com for more of Bill's insight. |
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