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The benefits of ETFs

Marketplace Staff Aug 3, 2007

The benefits of ETFs

Marketplace Staff Aug 3, 2007

TESS VIGELAND: Oil prices are soaring again. This week, crude hit new records as it gets closer and closer to $80 a barrel. That’s probably good news for investors who have put their money in oil ETFs, exchange traded funds. They’re betting big returns on funds that specialize in big oil.

But if crude isn’t your thing, Marketplace’s Jill Barshay reports on the wealth of ETFs burning up the market.

JILL BARSHAY: Arnold Graef works in an aircraft factory in Wichita, Kansas. About seven months ago, the letters E-T-F kept popping up on his brokerage account website.

ARNOLD GRAEF: I wanted to make sure it wasn’t some kind of fad or some kind of hoax.

Graef talked to colleagues. He read up on exchange-traded funds, or ETFs as they are commonly called, in personal finance publications.

This is what he found out: ETFs are a mutual fund that trades like a stock. Each ETF holds a basket of stocks that tracks an index, such as the Dow Jones Industrial Average. You can buy or sell the fund any time during the day, instead of having to wait until market close as you do with a mutual fund.

And there are no minimum investments. You could buy just one share if you wanted to. Or, you could do what Graef did:

GRAEF: I decided to go ahead and make the plunge. I actually have bought several of them, but I put together a mix, according to one of the portfolios of one of the articles I read about.

More and more Americans are taking the same plunge. There are $485 billion in exchange traded funds. In fact, there are 534 ETFs — double the number from one year ago. That’s according to the ETF Guide, a whole company that does nothing but track the ETF sector.

The biggest advantage is the low management fee cost. Simon Maierhofer started ETF Guide. He says the management fee of an ETF is cheaper than what you’ll get on most mutual funds. For instance, point .08 percent versus 1 percentage point.

SIMON MAIERHOFER: Calculate what the 1 percent of difference, what the financial consequences will be over 20-30 year time horizon, and you’ll be amazed how much money you can save in fees.

Let’s say you put $10,000 in S&P ETF. Your management fee for one year would be just 8 bucks. In a similar mutual fund, it could be a $100.

But not so fast. ETFs can be more expensive. When you buy an ETF, you pay a stock commission, just as if you were buying shares of IBM.

Tom Rampulla is head of ETF sales at the Vanguard Group. He says these trading commissions can make ETFs less of a bargain. Even if you pay only $7 or $8 for a trade over the web.

TOM RAMPULLA: If you put a little bit in on a periodic basis, the commissions and bid-ask spreads really start to eat away at your expenses. Whereas the open end mutual fund, if it’s a low-cost fund, it’s a much lower all-in cost.

Rampulla says to take your calculator out and add up your total costs with an ETF versus a mutual fund. And Rampulla also says to watch out for ETFs that are too tiny.

Wall Street is now creating very narrow, exotic ETF varieties, like the HealthShares Dermatology and Wound Care Fund.

Jeff Feldman is the chairman of Xshares, the company that created the dermatology fund. His funds can have as few as 20 stocks in them. He says his ETFs are for an investor who doesn’t want to bet on just one company’s new technology, but on the entire sub-sector.

JEFF FELDMAN: They’re all pretty niche-y. Like opthalmology, orthopedic repair, patient care services, respiratory and pulmonary diseases, infectious diseases.

ETFs that focus on niche-y segments of the market can be volatile. If that segment of the market tanks, so will your ETF. Even Feldman, the guy who’s trying to sell you these funds, says you shouldn’t allocate more than 4 percent of your portfolio to his niches.

The next frontier for ETFs is active management. Those new ETF funds effectively throw the index away altogether. Managers actively pick stocks or bonds, just as they do for ordinary mutual funds.

And someone’s got to pay the salary of the ETF fund manager. You’ve guessed it: expect those ETF management fees to rise.

In New York, I’m Jill Barshay for Marketplace Money.

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