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Exchange-traded fund popularity surges

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By Katherine Vogtcovered hospital and personal finance issues, physician/hospital relations, and ancillary health facilities for us during 2003-06. Posted June 14, 2004.

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In an industry prone to uninspiring jargon, investments with names such as Spiders, Diamonds and Vipers are bound to catch some attention.

But artful naming alone can't explain the surging popularity of these and other exchange-traded funds, a type of investment that has existed for a decade and has now matured into a popular vehicle for putting money in the stock market.

In a nutshell, exchange-traded funds (ETFs) are mutual funds that hold baskets of stocks designed to track various market indexes. But unlike traditional open-end mutual funds, these funds trade on exchanges throughout the day, like stocks.

The first ETF -- Spiders, based on the S&P 500 index -- debuted in 1993, with the second arriving in 1995 and more than a dozen trading by 1996. By the end of 2002, there were 113 ETFs trading with assets worth $102.1 billion, according to the Investment Company Institute, a national investment company association. By April of this year, the combined assets of the nation's ETFs were $162 billion with 134 funds.

"In the last five years there has been an explosion of them," said Marvin Appel, MD, chief executive of the Great Neck, N.Y., investment advisory firm Appel Asset Management Corp. "The initial appeal of these was to individual investors who would have otherwise been trading individual stocks. And then some of the more popular ETFs found favor among institutions."

Dr. Appel, an anesthesiologist turned investment adviser, said ETFs could be an appropriate investment tool for some physicians.

"The economic landscape of the medical field is constantly changing, and unfortunately usually for the worse. And so it's important for physicians to make the most of their dollars," he said. This is not the bull market of the 1990s, he added. "You're going to have to work harder for investment returns, and this is an excellent vehicle to do it."

Even so, Dr. Appel and other financial experts acknowledged that ETFs are not the right investment for everyone. Their brokerage fees might outweigh their benefits in some cases, so investors should consider their pros and cons before parting with money.

One advantage to ETFs is the flexibility of the funds compared with others. ETFs can be bought and sold throughout the day, unlike most traditional mutual funds that trade once a day. That means investors might get better prices on trades. Additionally, traders have the ability to short or buy ETFs on margin, tools that may be prohibited with other funds.

Jim Troyer, a Malvern, Pa.-based principal of the investment firm The Vanguard Group, said most individual investors probably don't need all that flexibility. His company offers Vanguard Index Participation Equity Receipts, or Viper shares, which track the small- and mid-cap Wilshire 4500 Index. Vipers are traded on the American Stock Exchange.

"If you're a long-term investor, at the end of the day does it matter if you bought it at 2 p.m. or 4 p.m.?" he asked. "They are a neat idea. They add flexibility for some people. But really, it's just a mutual fund that trades throughout the day."

Other advantages to ETFs are their tax efficiency and low management costs relative to other investments. Kevin Caron, portfolio manager for the financial firm Ryan Beck & Co. in Florham Park, N.J., said that when mutual funds are fully priced out, their annual fees can reach 3% of the asset under management while an ETF's fees might be 0.3%. He said the difference is caused by the fact that ETFs are not actively managed, so unlike traditional mutual funds, they are not paying portfolio managers.

James Angel, associate professor of finance at Georgetown University, said eliminating the active management of the fund could eliminate management errors. "You eliminate the manager risk, and that provides a lot of peace of mind," he said.

Because ETFs track indexes, investors know that they will get the return on that particular index, which also could give peace of mind. "The reason you like an index fund is that you know whatever it will be, it will be what the market is," Troyer said.

But index funds, either ETFs or mutual funds that track indexes, might show more average returns than the most high-performing mutual funds, which have the ability to be more selective in which stocks they own. As Dr. Appel put it, an index fund is akin to hitting a double in baseball. "I think most people still maintain the hope of going for a home run," he said.

Additionally, ETF investors may end up owning stocks that they don't want, such as those of tobacco companies. "If there are some companies in there that you don't want to own, it's very difficult to weed them out of an index fund," Caron said.

Another potential disadvantage to ETFs are brokerage fees. Even though their holding costs might be low, most individual investors have to buy ETFs through brokerage companies, and that creates commission costs. And investors who are constantly putting or taking out more money will pay for each transaction.

"This is a very good way of putting money into the stock market without having to deal with a lot of agonizing," Dr. Appel pointed out. "But they're not right for people who are adding money incrementally, such as a payroll deduction."

For those who wish to put their money in ETFs, there are many choices. There's Standard & Poor's Depository Receipts (SPDR), commonly called Spiders. They track the S&P 500 and trade on the exchange that created them, the American Stock Exchange. Diamonds, also created by and traded on the American Stock Exchange, track the Dow Jones Industrial Average. In fact, the American exchange trades more than 100 exchange-traded funds.

Caron recommends that investors talk to an adviser about what fund would be best, if any. "We certainly think there's latitude for both styles: the old-fashioned one-stock-at-a-time, building your own portfolio approach. There's also merit to this approach," he said. "I've seen people have success blending both."

Katherine Vogt covered hospital and personal finance issues, physician/hospital relations, and ancillary health facilities for us during 2003-06.

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ADDITIONAL INFORMATION

Growing exchange

Exchange-traded funds have grown in the last decade, both in numbers of funds and in their total asset value:

Funds Value
1993 1 $464 million
1994 1 $424 million
1995 2 $1.1 billion
1996 19 $2.4 billion
1997 19 $6.7 billion
1998 29 $15.6 billion
1999 30 $33.9 billion
2000 80 $65.6 billion
2001 102 $83.0 billion
2002 113 $102.1 billion
2003 119 $151.0 billion
April 2004 134 $162.0 billion

Source: The Investment Company Institute

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