A cautionary tale of Spiders, WEBS, Diamonds and Cubes
- By Milt x_Zall
- Sep 01, 2000
FAQ on Index Share Products [American Stock Exchange]
One of the hottest forms of investing these days is exchange-traded funds.
But even though financial planners are using them with some of their clients,
ETFs are not for everyone.
Exchange-traded funds — sometimes called index shares — are a hybrid of
index mutual funds and stocks. Like index funds, ETFs track a particular
market index by holding the stocks of that index.
Spiders, nicknamed SPDRs, or Standard & Poor's Depository Receipts,
track the S&P 500 index, and perform very much like the C fund in the
Thrift Savings Plan. Diamonds track the Dow Jones Industrial Average, Cubes
follow the Nasdaq 100, and WEBS (World Equity Benchmark Shares) track the
stocks of individual foreign nations. In addition, dozens of new exchange-traded
funds are being added that track other indexes and sectors of markets. Also
like index funds, some exchange-traded funds will reinvest dividends.
Dennis Filangeri, a certified financial planner in Metairie, La., notes
that unlike index mutual funds, ETFs trade like stocks. Spiders, for example,
trade on the American Stock Exchange under the ticker symbol SPY. Like any
stock, the price of an ETF moves up and down during the day, while mutual
fund shares are priced at the end of the market day. You can sell an ETF
short, buy on margin or set limit orders — all tactics you can't use with
an index fund.
Filangeri likes ETFs for several reasons. Perhaps the most attractive feature
is the tax advantages. One of the problems with any type of stock mutual
fund is that the fund generates capital gains through the buying and selling
of stocks, thus creating a tax liability for shareholders. This is especially
a problem during a down market when shareholders may force the sale of holdings
through heavy redemption demands. These tax liabilities aren't a problem
for funds held inside tax-favored accounts such as individual retirement
accounts and retirement plans, but they can be a big issue for any taxable
But ETFs don't buy and sell stocks, except to replace a stock that has been
replaced on an index. Readjustments might generate small capital gains for
investors, but generally the main tax liability investors will face is when
they sell ETF shares for a gain. ETFs could even be bought and sold to offset
other investment tax liabilities. This control of tax liability has long
been the attraction of owning individual stocks instead of funds. But many
investors can't afford to buy enough different stocks to be well-diversified.
ETFs solve that problem because they track all the stocks in their index.
Another attraction of ETFs is that they are usually cheaper than corresponding
index mutual funds. This is offset somewhat by brokerage fees, because ETFs
must be bought through a broker like any stock, but the fees shouldn't be
a big problem if you don't trade ETFs often.
Some of the same features that make ETFs an attractive substitute for index
mutual funds can also make them inappropriate for some investors, Filangeri
said. For example, because ETFs are stocks, investors may be more prone
to try to time trades. Mutual fund investors are less likely to watch the
markets minute by minute or make trades as often as stock traders. Not that
ETFs can't be invested in for the long term, but they are more tempting
to trade more often than index funds.
Filangeri also noted that ETFs aren't appropriate for investors who dollar-cost
average their purchases or redemptions. Buying small amounts of ETF shares
each month is expensive because of the brokerage fees.
A less well-known risk is that, like closed-end mutual funds, ETFs can trade
at premiums or discounts that vary from the net asset value of the underlying
index of stocks. An investor could thus lose money buying at a premium and
selling at a discount, even if the underlying index is doing well. Some
experts say the premium/discount risk is more likely to occur with ETFs
that track market sectors or international stock indexes.
Clearly, Filangeri said, exchange-traded funds offer some features that
help broaden an investor's options. But don't automatically jump into them
until you determine whether they're appropriate for your needs.
—Zall, Bureaucratus columnist and a retired federal employee, is a freelance
writer based in Silver Spring, Md. He specializes in taxes, investing, business
and government workplace issues. He is a certified internal auditor and
a registered investment adviser. He can be reached at email@example.com.