Of Mutual Interest Are you ETF-curious? Here are the ABCs of ETFs

By Mark Jewell

AP Personal Finance Writer

BOSTON (AP) -- Exchange-traded funds may be the best investment that you don't understand.

At 17, ETFs are coming of age, beginning to appear in college-savings plans and 401(k)s. They have low-cost appeal, typically charging lower investment fees than mutual funds, their more established rivals.

Yet ETFs have drawbacks, and still trail mutual funds on the most important measure of size. For every dollar in an ETF, U.S. investors have stashed $12 in mutual funds.

Still, at nearly $900 billion, ETFs are growing at a faster clip than funds, their assets doubling over the past four years.

But many people know little, if anything, about ETFs.

A recent Associated Press-CNBC poll asked more than 1,000 U.S. investors to rate six investment options as a way to build wealth. Mutual funds were the favorite, with ETFs finishing last, endorsed by just a quarter of those polled. About half had no feelings either way about ETFs.

Clearly, they're little understood. Here are some ETF basics, and a snapshot of current ETF trends:

Q: What are ETFs?

A: They're a twist on index mutual funds. Those funds typically charge less than actively managed funds because you're not paying for the expertise of professionals who pick stocks or bonds in hopes of beating the market.

ETFs are similar to index funds in that both track segments of stock or bond markets, trying to match a benchmark rather than beat it. But ETF shares can be traded during daily trading sessions just like stocks. That makes it possible to lock in a preferred price without waiting for a closing price. Mutual funds are priced only at the close of daily trading.

Most ETFs hold stocks, but a growing number track segments of the bond and commodity markets. There are higher-cost actively managed ETFs that try to beat the market, but they're a small part of the ETF universe.

Q: So are ETFs primarily for active investors who frequently trade?

A: Not necessarily. There's no reason investors can't buy ETFs and then take a mostly hands-off approach for decades, periodically rebalancing holdings to ensure they've got a risk- and age-appropriate mix.

Q: How actively are ETFs traded?

A: Many change hands frequently. On a typical day, ETFs make up about one-third of the trading volume on U.S. exchanges. Mostly, it's market pros such as managers of mutual and hedge funds trading ETFs to stay agile in fast-moving markets. Say a fund manager has lots of cash and wants to put it to work quickly without committing to specific stocks. ETFs offer a cheap, easy way to put money into the market and purchase a diverse group of stocks.

Q: How do I know I'm getting an accurate, up-to-the-moment price when I buy an ETF?

A: First, some explanation: Middlemen known as market makers run the behind-the-scenes business of matching buyers with sellers, and balancing investor demand for the securities that ETFs hold with the available supply. As with individual stocks, mismatches can occur, affecting pricing, sometimes at a cost to investors. ETF sellers must trade with other investors. That's a key difference with mutual fund investors, who simply buy and sell shares from the fund company.

Frequent ETF traders should know whether there's typically a significant gap between an ETF's asking price and its selling price. A larger "bid-ask" spread can make an ETF more expensive to buy and cheaper to sell, cutting into an investor's profits. The most frequently traded ETFs have the narrowest bid-ask spreads. The biggest and oldest ETF -- SPDR S&P 500, tracking the Standard & Poor's 500 index -- routinely has a bid-ask spread of around a penny on shares that trade for $125 apiece. In contrast, the spread can run around a dollar at times for ETFs that venture into narrower market segments. If bid-ask spreads are a concern, go with bigger ETFs rather than niche offerings.

Q: Then why might an investor choose an ETF tracking a small slice of the market?

A: Suppose you want to invest in an area where there are just a few stocks to choose from, and no index mutual fund that slices the market that narrowly. There's probably an ETF for you among the nearly 900 available to U.S. investors. If you believe chilly Norway will be the next hot foreign market, but are unsure which Norwegian stock to buy, consider the Global X FTSE Norway 30 ETF. Think there's money to be made on growing industrial demand for platinum? There's ETFS Physical Platinum Shares, an ETF that gives investors stakes in platinum-stocked vaults. Just be careful. Returns in such narrow pieces of the market can be extremely volatile.

Q: Where can I buy ETFs?

A: Through brokerages, which are vying for ETF business. In the past year, Charles Schwab, Vanguard, Fidelity, and TD Ameritrade have begun offering commission-free trades of select ETFs. Many of those companies also caution investors not to trade too frequently, since it's so difficult to consistently move in and out of the market at the right times. There are strings attached to the discount brokerages' commission-free offers. So check before you trade.

Q: How do ETF expenses stack up against mutual fund costs?

A: Many ETFs now undercut comparable index funds on cost. Recent industry data show the average expense ratio is 0.34 percent for stock ETFs. That's less than half the average for index funds buying U.S. stocks, and less than one-quarter the average for actively managed U.S. stock funds. An expense ratio measures the ongoing charges that investors pay, expressed as a percentage of assets. And ETFs don't charge loads, upfront sales costs that many conventional funds sold through advisers charge.

Q: With mutual funds, individual investors are sometimes charged twice as much in expenses as institutional clients who effectively get a bulk rate for the larger sums they invest. Is that the case with ETFs?

A: No. Expenses are typically the same regardless of how much is invested. And while mutual funds often require investors to start with a minimum of $1,000 or more, an ETF investor can start with the cost of a single share, typically less than $100.

It's one reason why Deborah Fuhr, global head of ETF research at BlackRock, which owns the iShares ETF family, expects ETF asset growth to top 20 percent in coming years.

"One reason they will continue to grow," Fuhr says, "is they are a very democratic product. The annual cost is the same regardless of whether I'm a retail investor buying a single share, or a pension plan investing hundreds of millions."

Published: Fri, Dec 24, 2010