Not All ETFs and Mutual Funds Are Created Alike; Know the Differences

June 18, 2008

by Tom Lydon

Exchange traded funds (ETFs) are gunning for the mutual fund throne.

But as investors try to figure out what’s right for them, it’s important that they know what the differences between the various types of funds happen to be, reports Cathy Pareto for Investopedia .

Mutual funds generally fall into two categories:

• Open-ended fund: These are the most common, as they dominate in both assets and volume traded. Purchases and sales take place directly between the investors and the fund company. The value of the shares are not affected by the number outstanding.
• Closed-end fund: These have a set number of shares and do not issue more shares as demand grows. Prices are driven by demand, not the NAV.

ETFs come in three forms:

• Exchange traded open-end index mutual fund: Dividends are reinvested on the day of receipt and paid to shareholders in cash each quarter. Securities lending is allowed and derivatives may be used in the fund.
• Exchange traded unit investment trust (UIT): These must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less and sets weighting limits for diversified and non-diversified funds. They don’t automatically reinvest, and pay cash dividends quarterly. An example of this is the PowerShares QQQ (QQQQ ) .
• Exchange traded grantor trust: It looks like a closed-end fund, but the investor owns the underlying shares in the companies and has the same voting rights as a shareholder. Dividends are paid directly to shareholders, not reinvested. An example of this kind of ETF are holding company depositary receipts (HOLDRs) .

Among the advantages ETFs have over mutual funds are:

• Greater trading flexibility, since they trade all day just like a stock.
• Fees are generally lower. ETF fees range from 0.07% to 1.25%, while mutual fund fees range from 0.5% to more than 10%.
• They have tax advantages for investors, as passively managed funds tend to realize fewer capital gains than actively managed mutual funds.

Small Companies Might Be Dinged By Active ETFs

June 18, 2008

by Tom Lydon

While the disclosure rules for actively managed exchange traded funds (ETFs) might benefit the investor who still craves transparency, the rules could inadvertently hurt small-company stocks.

The Securities and Exchange Commission (SEC) rules mandate that active ETFs must disclose their holdings each day, while mutual funds typically only make those disclosures once a month or even once a quarter.

The rules could wind up hurting smaller companies. Unlike the large- and mid-caps, who often see huge trading volume every day, the situation is a bit different for smaller companies. Their shares trade relatively rarely, making it a challenge for large funds to buy big stakes without causing a spike in market demand, which pushes up prices, reports Ian Salisbury for the Wall Street Journal.

As a result, active ETFs have so far stuck to primarily large-caps and short-term bonds. And those small-caps have been one area where active managers have found the most bargains, helping them beat index funds.

If you’re looking for some small-caps with your active management, PowerShares does offer a fund with some small-company holdings: PowerShares Active Alpha Multi-Cap Fund (PQZ ). They’re 17% of the fund. If you want more than that, patience is a virtue.

As managers get used to the concept of active ETFs, perhaps we’ll see some funds focused exclusively on the small-caps.

With Advent of Active ETFs, Will We See More CEF Conversions?

June 13, 2008

by Tom Lydon

Now that actively managed exchange traded funds (ETFs) are a reality, closed-end funds (CEFs) could begin seeing evolution in greater numbers.

Since the approval of the actively managed ETF, the CEFs that are trading below their net asset value (NAV) are leading managers to explore the possibility of opening them up into ETFs, reports Jesse Emspak for Investor’s Business Daily.

CEFs only issue a limited number of shares and new shares aren’t issued as investor demand grows, unlike ETFs. Prices aren’t determined by the NAV, but instead by investor demand. The fund represents an actively managed portfolio of securities, and they typically concentrate on a specific industry, sector or region.

Claymore/Raymond James SB-1 Equity Fund (RYJ ) is one CEF exploring a conversion. The board of directors has approved it, and it has to be run by the shareholders.

RYJ actually had a provision for making it an open-ended fund: if it trades at a discount of 10% or more over 18 months, or at 10% or more for 75 days in a row, it will convert. It never met the criteria, though.

ETFs have more than twice the assets as CEFs do, so perhaps this is something we may see more of in the future.

Future Success of ETFs

June 06, 2008

by Tom Lydon

Although actively managed exchange traded funds (ETFs) have hit the market, there is still debate as to whether or not they will succeed.

In their infancy, these ETFs don’t have a track record, which is one of the ways investors often select actively managed mutual funds. So it could take some time, reports Cardiff de Alejo Garcia of Financial News. Another issue is that institutional investors account for about 40% of ETF holdings and wouldn’t be interested in this type of product. They want the liquidity and transparency, which may be compromised in actively manged ETFs.

Regulators are still working on solutions to these issues, with ideas such as restricting the number of trades a single fund can make each week or requiring the fund to execute trades on the same day. As the product evolves, so too will a solution.

State Street conducted a survey recently of asset managers, banks and financial advisors. Form the survey they found that 60% of respondents have changed the way they construct portfolios because of ETFs. They like them for their liquidity (and the ability to short them), but find that some of them track untested indexes, which they see as a disadvantage. These responses seem to be in-line with the discussion on actively manged ETFs.

What Exactly Is an ETF?

June 05, 2008

by Tom Lydon

When it comes to exchange traded funds (ETFs), are there industry posers who are trying to disguise themselves?

Dan Dolan of the Select Sector SPDRs ETF family thinks so. Among the newer ETFs, a pure index tracker is hard to come by, and some of the newer products can only be quasi ETFs due to their border on active management. Dolan wants products to earn the right to be an ETF, not just call them that. Part of the reason Dolan is so adamant is that he sees the risk involved with these newer funds as cutting into the $600 billion industry, and undermining the benefits that got ETFs where they are today, reports Hannah Glover on Ignites.

Many free market advocates say they want the investor to decide what works and what doesn’t, as assets and ETF popularity can speak for itself. Still, there is the fact that the fancier fund types do have expenses which cut into returns; they may not have the same tax benefits ETFs tout; and have a complicated structure, all of which is the opposite of an ETF. But at the end of the day, there may be different layers of definitions for an ETF.

Ultimately, the SEC will have to decide how to regulate the troubles, and as an investor you will have to decide what works for your needs and investment goals by doing your research.

Open-Ended Funds of ETFs Slow to Grab Hold

June 03, 2008

by Tom Lydon

The concept of an open-ended fund of exchange traded funds (ETFs) has yet to gain any momentum. Could it be that the right time has simply not yet arrived?

Most of these types of funds are lass than two years old, and the aggregate of net assets of the group total $251.6 million, less than 1% of all fund assets, reports Richard Widows for The Street.

The most recently launched funds are Seligman Target ETF Fund 2035 (STZAX ) and the Seligman Target ETF Fund 2045 (STQAX ). which were released in October 2006. Year-to-date, they’re both down 1.1%.

These funds are available in institutional and retirement versions, and if you buy shares of these funds, Widows wonders if the ETF exposure may justify the expenses. The exception, he says, might be investors who are making small initial investments.

Investors interested in diversification beyond what they’d get in no-load index funds might find a reason to consider funds of ETFs, as well. However, while the sales charges would likely be less than the brokerage commissions on direct ETF purchases, the expense ratios of the funds would eat into holdings over time.

For investors who are waiting for ETFs to become a standard option in 401(k) plans might find these funds useful while they wait it out.