Building Portfolios With ETFs

Exchange-traded funds have exploded in popularity, but for many investors these investments remain something of a mystery.

Like traditional funds, ETFs hold baskets of securities and other investments. Rather than get priced once-a-day like a traditional fund, ETFs trade throughout the day, getting priced like stocks

ETF assets stand at $251.5 billion, having increased $100 billion over the past year and a half. While growing strong, ETFs remain small compared with traditional funds, which have $8.5 trillion in assets.

More banks and brokerage firms also have added ETFs to their investment lineups, according to James Parsons, a managing director of iShares at Barclays Global Investors, a unit of Barclays PLC and the largest provider of ETFs. These institutions are creating what they call wrap programs, in which advisers manage assets for a fee, either working with a client to pick investments or using an investment model created by the institution.

Even Vanguard Group, a fund company that has long catered to do-it-yourself investors and is playing catch-up in the ETF market, recently arranged to have brokers at Morgan Stanley, UBS AG’s UBS Financial Services, Wachovia, Citigroup’s Smith Barney, Raymond James Financial and other financial institutions sell its ETFs, called VIPERs.

With ETFs increasingly challenging traditional funds for investors’ attention, it is important to remember traditional funds have certain advantages, particularly for people who invest small sums at regular intervals. Because ETFs trade like stocks, investors pay a brokerage commission each time they buy or sell one, making them impractically expensive for people who like to add regularly to investments.

Many of the funds, with names like SPDRs, VIPERs, Dow Diamonds and iShares, track an index and carry lower ongoing fees than traditional mutual funds. They offer the ability to instantly diversify a portfolio, by tracking everything from the broad Standard & Poor’s 500-stock index to indexes that focus on sectors, geographic regions, countries and investing styles. They also tend to be more tax-efficient than traditional funds since they don’t have to sell shares — and pay out capital-gains distributions — when investors want to withdraw money.

Still, about half of the new accounts coming into Northwest Capital Group, a financial advisory group within Smith Barney, have opted for portfolios made up purely of ETFs through an option launched by the group in 2002, according to John Stoeser, a partner with Northwest Capital. The company calls the option its index portfolio strategy.

“For the most part, investors are familiar with indexing as a strategy but somewhat unfamiliar with ETFs, so there is an education process,” Mr. Stoeser says.

Indeed, the big advertising push unfolding on commuter-train platforms, in mainstream magazines, on television and elsewhere is bringing the notion of ETFs to ever more investors. But the education process is just beginning.

“I find that most investors are not familiar with ETFs before we recommend them. However, they seem to grasp the concept easily,” says Michael Joyce of Michael Joyce & Associates, a financial adviser in Richmond, Va.

Mr. Joyce has been recommending ETFs to his clients since 1996, three years after the first one was launched, and continues to see a lot of benefits. Still, none of his clients has all or even half of a portfolio in ETFs. At most, the investment vehicles make up 20% to 30% of any portfolio, he says.

“It goes across the spectrum,” Mr. Joyce says. “People with smaller amounts of money would have higher percentages of ETFs because we want to establish diversity before adding value by picking individual stocks.”

Among the firms beefing up their efforts to educate investors about ETFs is Charles Schwab, already one of the biggest distributors of ETFs to individual investors.

Charles Schwab plans to start offering free information about ETFs on its Web site to the public, probably next year. It also will expand the information on ETFs already available to clients.

Despite the firm’s established niche in the ETF market, there’s room for it to grow: ETFs still make up only a small portion of its business.

Fidelity Investments, which launched an ETF center on its Web site in December that allows investors to trade ETFs, includes an overview of what ETFs are and how they work. Investors are starting to understand these investments “a little more broadly,” says John Sweeney, senior vice president for mutual-fund products at Fidelity.

David Elan, a financial adviser in Boston, is another big proponent of ETFs who spends significant time explaining the ins and outs of the funds. “About half of the time, people already know what we’re talking about,” says Mr. Elan, who puts together portfolios made up almost exclusively of ETFs.

Mr. Elan manages money for individuals and nonprofit organizations with between $250,000 and $2 million. What are the obstacles to convincing a client that ETFs are the way to go? “It’s not really that they’re concerned about potential problems,” Mr. Elan says. “It’s just that we sometimes have to explain to people that switching to ETFs is like switching to compact discs after listening to music on vinyl records. It is the same music, but in a better storage medium.”

So amid all of the noise about ETFs, what are the pros and cons of ETFs?

First and foremost, they can be significantly less expensive than traditional mutual funds. Fees on ETFs average 0.42% of assets annually, compared with fees of 0.86% for traditional index funds and 1.4% for actively managed mutual funds, according to Morningstar Inc., a Chicago investment-research firm.

Very-low fee ETFs include the Vanguard Total Stock Market VIPERs, with fees at 0.07% of assets, and the Vanguard Large-Cap VIPERs, also at 0.07%. The iShares S&P 500 Index Fund charges fees of 0.09%.

However, there is a caveat.

ETFs are “sold as being much cheaper than traditional mutual funds, but there’s also a big difference between the [fees] of different ETFs,” says Dan Culloton, a Morningstar analyst. “It would be foolish not to compare relative differences between the costs of ETFs.”

Barclays iShares are cheap, for example, but Vanguard’s VIPERs are even cheaper, Mr. Culloton notes. The average fee on iShares ETFs is 0.43%, compared with an average of 0.18% for VIPERs.

David Yeske, a financial planner at Yeske & Co. in San Francisco, says it cost him $79 to buy a Vanguard mutual fund that tracks the S&P 500 through Charles Schwab. But he says he can now buy as many as 1,000 shares of an ETF that tracks the same index for a commission of $9.99 at Schwab, which prices mutual-fund trades differently than stock trades. “The mutual fund and the ETF are both giving exposure to the S&P 500, but the ETF is doing it more cheaply,” he says. He adds that some ETFs are doing reverse stock splits to make their shares “expensive” enough so people can make sizable investments while staying under the 1,000-share ceiling that many firms put on their most-attractive commission rates.

There are times, however, when it might make more sense to buy a traditional open-end mutual fund, Mr. Yeske notes. One example he cites is the case of an investor who wants to reinvest dividends. That can be done with many traditional mutual funds, but it can be hard or impossible with ETFs, he says.

Traditional funds also offer more choices for investors who want to put part of their portfolio into bonds. Right now, there are only about a half dozen fixed-income ETFs and none focuses on high-yield, municipal or foreign bonds, says Mr. Stoeser of Northwest Capital.

Investors also should beware of switching to automatic pilot after purchasing just one or two ETFs, he warns. “I’m afraid when investors think about ETFs, some are going to say, ‘Oh, I can just buy a single ETF for my account and hold it,’ ” says Mr. Stoeser. “That’s not optimal because you’re missing out on a whole universe of opportunities to further diversify the risk in a portfolio.”

Northwest Capital includes about a dozen ETFs — with some that track the broad market as well as those that track specific sectors, foreign-stock markets and bonds — in its index portfolio strategy.

Tax efficiency is another benefit of ETFs. When an investor in a traditional mutual fund wants to sell a large number of shares, the manager must sell some securities in the fund to raise money. That can result in a capital-gains distribution, which is taxable to all shareholders in the fund. With ETFs, shares are bought and sold by investors on an exchange, which doesn’t trigger capital gains for the fund’s remaining investors.

“My clients thus far have received no capital gains on any of the ETFs I’ve used,” says Marc Rosenbach, senior vice president, investments, at UBS Financial Services in Beverly Hills, Calif.

Mr. Rosenbach switched to an all-ETF approach about 18 months ago for clients in his advisory wrap accounts and has already put $100 million of their assets into the ETF accounts. He says the clients are pleased with the results.

Hedging is another potential advantage ETFs offer over traditional mutual funds. Mr. Joyce of Michael Joyce & Associates gave a hypothetical example of a client who holds a lot of stock in pharmaceutical companies — say the employee of a drug company who owns company stock. “To hedge that position, we might short a health-care ETF, for example the iShares health-care fund,” Mr. Joyce says.

A key benefit of ETFs — their ability to trade all day, unlike mutual funds which are priced once a day — can become a drawback if investors aren’t careful. “If you’re trying to put a couple hundred dollars per month into ETFs … you’re going to have brokerage costs each time, and depending on the amount of money you’re investing, it can be more expensive than just having mutual funds,” says Mr. Joyce.

A clear sign that the ETF market is poised for growth is the increased interest by banks and brokerage firms in including ETFs in their offerings to investors. Early on, ETFs established themselves with institutional investors, but they are now poised to make inroads with individual investors, says Martha Papariello, principal at Vanguard Financial Advisor Services.

“The growth on the part of investors who use financial advisers represents an intriguing opportunity to us,” she says.

Vanguard has seen its assets in VIPERs more than double to $9.2 billion over the past 12 months. Its recent arrangements with brokerage firms underscore its belief that the ETF market will continue to grow.

For the past two years, Barclays has been holding road shows around the country to educate brokerage firms and advisers about ETFs. This fall, it is holding meetings in eight cities and drew interest from some 2,700 financial advisers. “The emerging trend that we’re seeing is really just the transition from explaining to financial advisers why these make sense to explaining how you use them,” says Barclays’ Mr. Parsons.

Barclays got in on the ground floor several years ago as companies ranging from Morgan Stanley, UBS, Merrill Lynch and A.G. Edwards began developing investment platforms that include ETFs, he says.

Barclays provides no financial incentives for advisers to use its ETFs, Mr. Parsons says. The payoff, he says, is that by educating advisers about the investments, more people eventually buy them. “I can’t even track who buys and sells my product; that’s why we have such a broad-based approach,” says Mr. Parsons.

As for advisers, the biggest financial incentives they have for recommending an ETF over an open-end mutual fund are the lower trading costs and lower continuing fees associated with purchases of ETFs, says Mr. Yeske, the financial planner.

“The incentive, such as it is, involves trying to minimize client costs,” he says. There are some exceptions, however. If an investor is buying Vanguard index funds directly from Vanguard, he may find that ETFs aren’t that much better a deal, though a long-term investor “might justify paying a commission” if the internal, fund-level expenses are a lot lower on the ETF, Mr. Yeske says.