Lonnie Williams learned a hard lesson when he lost half his investment in tech-heavy mutual funds a couple of years ago. "I had a tendency to jump into things just before they're about to crash and burn," he said.
Now, the 38-year-old Michigan art director is out of those mutual funds and easing back into the market using an emerging breed of investment - exchange-traded funds, or ETFs, which passively track an index such as the Standard & Poor's 500 but trade like a stock. "I'm sold on them."
Michael G. Freeman, a business owner and longtime investor, has spent enough years in the market that he says he's had a "nice profit" on even the most growth-oriented of mutual funds. But the Kansas resident is now primarily using ETFs in his portfolio as he's getting closer to retirement and looking for a low-cost way to fine-tune his holdings.
Across the country, investors big and small have poured billions of dollars into ETFs over the last few years, boosting their total assets to about $93 billion - and giving mutual funds a run for their money.
ETFs are built much like mutual funds, containing a basket of investments representing a particular index, such as the S&P 500. But unlike mutual funds, which are priced and traded at the end of the day and have other limitations, ETFs work like stocks. You can trade an ETF at market price in the middle of the day or place a stop or limit order. You can buy ETFs on margin or sell them short.
Some investors are turning to ETFs as a more tax-efficient and low-cost way to invest compared to mutual funds, while others are giving up on actively managed, underperforming funds and becoming big believers in passive index investing.
Judging by the estimates of some industry specialists, and the actions of individual investors including Williams and Freeman, ETFs may increasingly take market share from mutual funds.
By 2007, total ETF assets will grow to between $445 billion and $1 trillion, according to industry specialists cited in a recent report by Financial Research Corp. in Boston. But another study, released by Lipper this summer, found one early estimate of an ETF market worth more than $500 billion by 2005 was "wildly high." (Mutual funds, by contrast, currently have about $7 trillion worth of investors' money, according to the Investment Company Institute, a trade group.)
The growing popularity of ETFs is "really due to a number of factors," said Gus Fleites, managing director for the advisory strategies group at State Street Global Advisors in Boston. But "first and foremost, they've benefited from the whole increased appetite among all investors for index-based investments."
In general, index investing has been gaining fans, as only 30 to 40 percent of actively managed mutual funds beat the S&P 500 index in any given time period. And index investing through ETFs has been gaining in particular because ETFs are more low-cost and tax- efficient than the lowest-cost index mutual fund.
In the decade since State Street Global Advisors created the first ETF to track the S&P 500 - nicknamed "Spider," or SPDR, for Standard & Poor's Depositary Receipt, with the ticker symbol SPY - the number of such index-based investments has grown to more than 100, according to the ICI. There are now "Cubes" (ticker QQQ) to mimic the Nasdaq 100 and "Diamonds" (ticker DIA) to follow the Dow Jones industrial average, as well as multiple international and sector offerings tracking a variety of indices. The latest entry in the burgeoning field: fixed-income funds.
Even Vanguard, the firm that created the first index mutual fund, has hopped on the ETF bandwagon, recently creating "Viper" shares, one version of which tracks the Wilshire 5000 index (ticker VTI), in direct competition with Vanguard's own Total Stock Market Index mutual fund.
Now, some investment firms, wanting to capture more of investors' dollars, are urging the Securities and Exchange Commission to approve actively managed ETFs, not just the passive kind that mimics a market index.
The SEC recently sought public comment on this but expressed concern over potential regulatory issues, such as conflicts of interest for actively managed ETF investment adviser and discriminatory treatment of different types of shareholders.
Like index mutual funds, ETFs are lower cost and more tax efficient than actively managed mutual funds because there are no expenses for research and active trading of stocks. The manager of an index mutual fund or ETF basically buys and holds the stocks represented in the particular index.
ETFs also are more tax efficient than index mutual funds, because they don't need to sell underlying individual stocks and incur possible capital gains the way index mutual funds do when investors seek to sell shares. ETFs are structured so that sellers go to the stock market and find buyers for the ETF shares, without the need for the ETF manager to sell underlying stocks at possible capital gain. (ETFs may spin off taxable gains just like index mutual funds, however, whenever the underlying index changes and a stock must be sold.)
The investment can work for both buy-and-hold types and traders, for both large and small investors. If you're a small buy-and-hold investor and don't have the usual $3,000 minimum to open an index mutual fund account, you could start by buying 10 shares of Vanguard's Total Stock Market Vipers, trading at about $85 a share. You could go through a discount brokerage and usually pay as little as $10 to $30 for the trade.
But it can get expensive for the little guy when he tries to implement a dollar-cost averaging program of buying a small set- dollar amount in an ETF on a regular basis. Usually, such a dollar- cost averaging program directly through a no-load mutual fund is free, presuming you've met the minimum dollar amount to open an account. Trying to do that through an ETF means you'd have to pay a transaction cost every time you bought the set amount. So if you're investing only $100 a month, it can be too expensive to pay $10 to $30 per trade.
Williams, the Michigan art director, is a small buy-and-hold investor and has figured out a way that works for him. He's investing $320 a month in a variety of ETFs, paying $12 a month through an online brokerage called Share builder.com.
While that amounts to 3.75 percent of the amount he's investing, Williams says he doesn't mind. "I could squirt that away in late fees at the video store."