According to a March 2008 report by State Street Global Advisors. investments in ETFs are predicted to grow 30 — 40% in 2008 following a growth rate of 45% to $608 billion in 2007.

The number of very large Exchange Traded Funds is also growing. According to State Street, there were 92 ETFs with a market capitalization of over $1 billion at the end of 2007, up from 72 at year-end 2006 and just 10 in 2001.

Why are investors moving so much money into ETFs and not to mutual funds?

Simply put, ETFs are a better way to invest. They meet all of the requirements of sound investing practices. ETFs are low cost, tax efficient and provide instant diversification.

Mutual funds have served investors well since they came on the scene in 1930s. By enabling the investment of small amounts at a time and providing professional management, mutual funds have helped U.S. investors amass more than $10 trillion.

However, today’s investors are more demanding than their parents and grandparents. They aren’t willing to bear the high cost and tax inefficient nature of mutual funds when better alternatives are available. They are frustrated with the inability to set a limit price for buying or selling and with not knowing where a fund is invested for months at a time.

In the way that mutual funds were one of the greatest inventions of the 20th century, ETFs are taking on that title for the 21st century.

This article starts with better defining ETFs and their advantages. Then, two of the main drawbacks of mutual fund investing are explained and illustrated with examples. The article finishes with a recap of the pros and cons of investing with ETFs.

ETFs Defined

1. ETFs are not investments, they are a way to invest.

ETFs are not an asset class like a bond or a stock. Rather, they are a vehicle for investing in stocks, bonds, gold, oil and several other asset classes.

2. ETFs are not stocks or mutual funds, they’re ETFs.

ETFs are often described as a cross between a stock and a mutual fund and that is true to the extent that ETFs offer the best of both worlds.

ETFs are like stocks in that you can buy and sell them the same way. ETFs are traded on the major markets and the price is set by buyers and sellers in real time. Compare that to mutual funds where you are forced to trade with the manager who unilaterally sets the price after the market closes.

ETFs are like mutual funds in that they offer a quick, easy way to diversify your investment — for example, ETFs must hold a minimum of 20 securities. Investing in just one stock will help you gain exposure to an industry trend, but also leave you vulnerable to single stock risk — the possibility that a stock blows up due to issues unrelated to the industry or economy (think Enron).

The kicker is that the market doesn’t reward you for taking single stock risk — you will do just as well in a diversified portfolio with less risk. For proof, google Harry Markowitz and Nobel Prize.

3. ETFs are for individual investors as well as for the pros.

Although the professionals discovered ETFs first, individual investors can benefit just as much from using them for long term investing.

First, since ETFs were only introduced a few years ago, they offer several advantages over mutual funds which are burdened by characteristics from their original introduction in the 1930s. For example, ETFs are low-cost and tax efficient relative to most mutual funds. In many cases investors can save 200 — 300 basis points (2 — 3%) every year with ETFs and that’s compared to a NO-load mutual fund (for more see below Mutual Fund Tax Nightmare ).

Second, ETFs come in a lot flavors (almost 700 at last count) to fit almost any situation. For example, if you are just beginning to save and invest, plain vanilla ETFs are available at very low cost to get you going. On the other hand, if you have a very complicated portfolio, you can find very specialized ETFs to fill in a hole or mitigate risk.

4. You can invest a small amount on a regular basis without getting crushed by commissions.

Since you buy ETFs the same way that you buy stocks, you will have to pay a commission. However, some innovative brokers have introduced programs that let you buy small amounts on regular basis for only a small fixed fee. For example, see the section below entitled Pros and Cons of ETFs where we mentioned Sharebuilder.com and their 20 trades for $20 program.

5. If your financial advisor is not actively suggesting ETFs, find another advisor.

If you just can’t bear to part with your FA, at least do them a favor and send them a link to this article.

The High Cost of Mutual Funds: Part 1

One of the reasons that mutual funds will eventually go the way of VCRs, analog television and afternoon newspapers is their high cost.

According to the Securities and Exchange Commission publication Mutual Fund Investing — Look at More Than a Fund’s Past Performance. tip number one is to scrutinize the fund’s fees and expenses. Specifically,

A fund with high costs must perform better than a low-cost fund to generate the same returns for you.

Got it. However, the SEC goes on to say something even more meaningful:

Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858.

Coincidentally, the expense ratio of the typical ETF is in the 0.4% to 0.5% range — compare that to the expenses of your mutual funds. Here’s a quick and easy way.

The SEC recommends using FINRA ‘s calculator to find out how much mutual funds are eating into the future value of your portfolio. We plugged in a couple of random large cap mutual funds and compared the expenses and future value against iShares S&P Global 100 Index Fund (NYSEArca: IOO ).

Using conservative figures like a starting portfolio of $100,000 and an expected annual return of 7%, the difference in the ending values are breath taking:

Despite the assumption of identical investment returns, the ETF outperforms the first mutual fund by almost $50,000 and the second fund by $65,000 over a 20 year period. To avoid embarrassment, the names and tickers of the mutual funds which are both from well known fund-families have been disguised.

Learn more about the Financial Industry Regulatory Authority (FINRA) here.

High Cost of Mutual Funds — Part 2

Part 1 of the High Cost of Mutual Funds covered how to use the FINRA calculator to determine the portfolio building power of using an ETF in place of a mutual fund over a long period time.

In part 2, another example is presented using a real case and a shorter time horizon.

Specifically, you will see how to save over $12,000 of expenses on a $100,000, 5-year investment by using ETFs in place of mutual funds.

In a recent column in the Wall Street Journal, there is an excellent overview of investment options available to investors looking for exposure to India entitled Heading East (Shefali Anand, April 21, 2008).

The author notes that several funds have recently launched to give investors a choice on gaining exposure to India. One of the major differences between the products profiled is the cost.

Per the article, here is the cost of investing in India across the different choices, using $100,000 as the benchmark investment:

1. Eaton Vance Greater India Fund: 2.14% or $2,140 per year

2. Franklin India Growth Fund. 2.30% or $2,300 per year

3. JP Morgan India Fund. 2.00% or $2,000 per year

4. Greenwich Advisors India Select Fund. 2.35% or $2,350 per year

Mutual Fund Average 2.20% or $2,200 per year

1. iPath MSCI India Index ETN (NYSEArca: IPN) 0.89% or $890 per year

2. WisdomTree India Earnings ETF (NYSEArca: EPI) 0.88% or $880 per year

3. PowerShares India Portfolio (NYSEArca: PIN) 0.78% or $780 per year

ETF/ETN Average 0.85% or $850 per year

Over a 5 year period, assuming no change in asset value, you would save $6,750 by going with an ETF or ETN. You would save even more as the value of the investment grows.

To be fair, you should add in the cost of establishing the positions. For the ETF position, add in the $12 broker commission. For the Eaton Vance and Franklin Funds, add the 5.75% sales loads. Taking into account the cost of establishing the $100,000 position, ETFs would save you an additional $5,738 over mutual funds for a total savings of $12,488 over the five year investment.

Another consideration, the mutual funds all have minimum investments ranging from $1,000 to $2,500. The minimum for the ETFs and ETN — none.

High Cost of Mutual Funds — Part 3

Another draw back of mutual funds is the immediate and continuous exposure to capital gains taxes that both new and long-term investors take on as shareholders.

According to Lipper analyst Tom Roseen. mutual fund taxes totaled $33.8 billion in 2007, up 42% from the prior year.

On a performance basis, investors did even worse with taxes reducing returns by 1.77 points in 2007 compared to 1.3 percentage points in 2006.

The WSJ’s Eleanor Lase has the full story in her article Index-Tracking Funds Can Lessen Tax Bite (April 27, 2008 ).

Roseen’s full report is available for purchase on Lipper’s website .

Mutual Fund Tax Nightmare

To reinforce the point about the detrimental effect of capital gains taxes on the future wealth of mutual fund investors, here is a case study straight out of the portfolio of a high-profile financial journalist.

In the June 2008 issue of Money . managing editor Eric Shurenberg laments about the tax bill that accompanied the poor 2007 performance of one of his favorite mutual funds — T. Rowe Price Small Cap Value (Ticker: PRSVX. down 7.03% for the 12 months ended 4/3/08).

It turns out that in 2007, the fund made one of its largest capital gains distributions in years while effectively finishing the year where it started.

The chart below illustrates what happened (Source: Yahoo Finance ).

If you made the mistake of buying the fund on December 17 for $39.99, you would have found yourself in a position on December 18 of holding a fund worth $35.40 and a taxable check for $5.16.

$4.85 of the $5.16 was a long term capital gains distribution, taxable at 15% or $.73 per share. $0.73 on $40 is 1.8%, so investors unlucky enough to get in before December 18 were immediately down almost 2 points on their investment.

The balance of the $5.16 was short term capital gains and dividends which have tax rates that can vary, so we’ll set those aside — but you get the point.

Is this situation unusual for mutual fund investors? Unfortunately no. Schurenberg cites Lipper’s Tom Roseen. The typical fund loses nearly two points of return to taxes on distributions each year.

Recap: Pros and Cons of Investing with ETFs

For the typical investor, ETFs line up very well with the fundamentals of good investing. They are diversified. low cost and tax efficient.

Diversification is almost automatic. By regulation, a domestic ETF must hold at least 13 securities and cannot invest more than 30% of the fund in any one security or more than 65% in the 5 most-heavily weighted securities. For international ETFs, the rule is a minimum of 20 securities and a limit of 25% in one and 60% in the top 5. Most ETFs hold many more securities and have a maximum concentration of 5 to 10% of the fund.

ETFs are very low cost relative to their mutual fund cousins. Depending on which study you cite, ETFs have an average expense ratio of 0.4% of assets and no sales loads. Compare that to an annual expense ratio of 1.4% for mutual funds, many of which also come with sales loads. Although a 1% per year difference may not sound like much, it adds up over time. See the section above for information on the free tool from FINRA that will calculate the cost differences between different funds over time. In our example, we calculated a $50,000 — $65,000 savings over a 20 year period.

ETFs are tax efficient because they operate differently than mutual funds. If you buy a mutual fund, you are trading with the fund manager. Share redemptions causes the manager to sell investments to raise cash and creates a tax liability for the remaining shareholders regardless of how long they have held the fund’s shares. This is a major problem for mutual fund investors who paid nearly $34 billion in taxes in 2007.

ETF managers don’t redeem shares for cash — they simply transfer a basket of securities to the redeeming party in a tax-free transaction. As a result, the remaining beneficial owners of the ETF aren’t handed an unexpected tax liability.

As an individual investor, you will typically buy and sell ETF shares on a secondary market rather than trade directly with the ETF sponsor. A taxable capital gains event will occur only when you sell the ETF (there are exceptions — review the ETF’s prospectus with your tax advisor).

There are several other pros to investing with ETFs. They have opened up investment opportunities previously limited to the realm of hedge fund managers and institutions — for example, you can execute a currency strategy very popular with institutions with the PowerShares DB G10 Currency Harvest Fund (Amex: DBV ).

ETFs make it very easy to pursue strategies that used to be hard to execute — e.g. buy/write strategies, borrowing shares for shorting purposes and investing in hard assets such as gold or silver.

There are cons associated with ETFs. For example, because ETF investing typically requires paying a commission to a broker, investing small amounts of money on a regular basis can be cost prohibitive. Some brokers are working to fix this — for example, ShareBuilder.com offers investors on an automatic investment plan $4 trades or 20 free trades per month for a $20 subscription fee.

Because ETFs are relatively new, they do not adequately cover all investment options. For example, although the markets for stocks and bonds are roughly the same size, the number of fixed income ETFs is only a fraction of equity ETFS. This will likely correct itself as new ETFs pass through the regulatory approval process and come to market.

Finally, specialized funds such as leveraged and inverse ETFs are very powerful investment tools that can do a lot of damage if not used wisely — best to leave these in the hands of your financial advisor.

To learn more about Investing with ETFs, visit the ETF MarketPro’s Investor Education Center or subscribe to ETF Investor Insights .