Exchange Traded Funds Offer Asset Allocation Opportunities

Caroline Maxwell, Investors Offshore.com

22 February 2001

This year, savvy investors will be looking at spiders, diamonds, and qubes as asset allocation tools, according to some experts. 'Experts in what?' I hear you cry. 'They're clearly talking nonsense!' Well actually, they aren't. SPDRs, DIAMONDs, and QUBEs are three of the better known Exchange Traded Funds (or ETFs), a relatively new investment opportunity which has grown greatly in popularity of recent times.

ETFs are basically index funds that can be traded on the market in the same way as shares, and which are designed to replicate the performance of an index, or basket of stocks. As Tom Taggart, managing director of Barclays Global Investors in San Fransisco explains: 'ETFs are asset allocation tools. When you're buying them, you're buying a specific slice of the market.'

The first ETF to appear was the SPDR, introduced on the American Stock Exchange in 1993, and designed to track the performance of the Standard and Poors 500 index. By the year 2000, the SPDR held over $17 billion in assets, and with its increasing popularity came others. DIAMOND, based on the performance of the Dow Jones Industrial Average was introduced in 1997, and was followed in 1999 by the QUBES ETF, which tracks the NASDAQ 100 index, and one year after launch, held over $11 billion in assets, and had completed a 2 for 1 stock split.

According to supporters, ETFs have many advantages over traditional mutual funds, not least of which is that with an Exchange Traded Fund, the investor is in the driver's seat, and can exert a greater influence on the overall make up of his portfolio 'basket'. ETF expense ratios are almost invariably lower than those of traditional mutual funds, partly because they do not need to pay a professional portfolio manager to pick stocks, and partly because indexing reduces the amount of buying and selling a portfolio does. The funds are also widely thought to be more tax efficient than traditional mutual funds for the long term 'buy and hold' investor, as capital gains are created when he chooses to sell the stock, rather than at the whim of a mutual fund manager. Trades can be executed throughout the day, and there is usually no minimum investment requirement.

However, there are disadvantages to investing in Exchange Traded Funds, the largest of which is the transaction fees to buy them, which can be high for small purchases (but conversely, small for large purchases). Since ETFs are traded through brokerages, investors are obliged to pay commission on transactions, and as a result, although ETFs seem to represent a very good deal for those with a lump sum to invest, anyone making small, frequent investments might be better off considering a no-load mutual fund.

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