Exchange Traded Funds (ETFs) are growing.  Investors are choosing 
low annual expense and market return over high annual expense and 
promised performance.

Total ETF inflow is growing faster than Mutual Fund inflow.  ETF 
inflow grew from $42.5 billion in 2000 to $54.4 billion in 2004. 
In contrast, mutual fund inflow fell from $309.4 billion in 2000 
to $180.3 billion in 2004.  Standard & Poors Depositary Receipts 
Trust (SPY) is the largest and oldest ETF.  From the one fund SPY 
started in 1993 the number of ETFs has grown to 150 in 2004.

Growth of ETFs is fueled by investors searching for market 
performance.  About 20% of conventional mutual funds do beat the 
market.  The puzzle is which funds will win, in the future. 
ETFs, on the other hand, have a reasonably good record of 
matching the performance of their underlying index.  For 
instance, in 2004, SPY value grew 10.92% and the value of the 
underlying S&P 500 index grew at 10.88%.  The promise of the 
conventional mutual fund is that it will deliver superior 
results.  The promise of the ETF is that it will match the 
performance of its underlying index.  

Expense for ETFs is less than for conventional mutual funds.  A 
prime reason for the mutual funds’ higher expense is that pros 
perceived capable of superior results are more expensive than 
technicians paid to duplicate the holdings of an index.  ETFs are 
passive investments and don’t require the active management of 
pros.  Investors moving money from mutual funds to ETFs are 
trading promised performance and high expense for market returns 
and low annual expense.  ETFs generally have expense ratios below 
1.  SPY’s expense ratio is .12.  Expense ratio is percent of 
assets consumed by fees annually.

Investors sticking with mutual funds have a couple of things 
going for them.  Eliot Spitzer has used his New York State Office 
of Attorney General to scare/shame mutual funds into minding 
fiduciary duties to their investors.  The growth of ETFs is 
pressuring mutual funds to reduce their expenses and to introduce 
ETFs mimicking mutual funds.  Investors sticking with mutual 
funds might benefit from the growth of ETFs.  However, mutual 
funds might have a hard time delivering.  Slowing growth or 
actual decline in fund size will make it difficult to reduce 
their expenses enough to keep investors happy.  The more 
investors defect the fewer left to share the expense.

ETFs trade like stock equities.  They can be bought and sold 
whenever the market is open.  They can be shorted, purchased on 
margin, and optioned.  Most brokers charge a commission for every 
buy and sell transaction.  This can be a problem for small 
investors building a portfolio with monthly contributions.  There 
is at least one broker that charges an annual fee rather than per 
trade commissions.

ETFs are passive.  They only trade when changes are made to the 
composition of the underlying index.  Fewer trades mean less tax 
consequence.  Mutual funds often have taxable capital gains, 
sometimes even in years when the fund has declined in value (sell 
winners and hold losers).

That 20% of mutual funds beat the market is a premise.  It 
assumes multiply years and a market defined as the S&P 500.  Meg 
Richards writing for The Associated Press reported that for 2004:

 * The S&P500 bested 61.6% of actively managed large-cap funds.
 * The S&P400 bested 61.8% of actively managed mid-cap funds.
 * The S&P600 bested 85% of actively managed small-cap funds.


The probability of a mutual fund having beaten the market in 2004 
is low.  Of course, relative performance changes from year to 
year.  Relative performance, of active versus passive management, 
changes.  Relative performance, of individual actively managed 
funds, changes.

The best ETFs strategy for small, beginning, busy investors is to 
‘buy and hold’ SPY.  If you are bigger, experienced, or have time 
on your hands you can try a more active strategy.  A strategy 
that beat the S&P500 over the last three years is to hold equal 
amounts of five large diversified ETFs and rebalance weekly. 
This strategy is in some ways just an expansion of our definition 
of ‘the market’ beyond the S&P500.  This strategy since inception 
3 years ago has beaten the S&P500 just over 1% annualized.  This 
small gain means rebalancing weekly is only viable when it is 
without trading cost.  A more aggressive strategy is to monitor 
50 ETFs and hold the most oversold, rebalancing weekly.   This 
strategy since inception 2/27/04 has beat the S&P500 by 16%.  

Remember.  ETFs’ popularity is on the rise.  They trade like 
stocks.  They have lower annual expense than mutual funds.  Their 
objective is to mimic the performance of an index.  They don’t 
beat or lose to the market, they are the market.  It is usually 
best for low maintenance, ‘buy and hold’ investors to define the 
market as broadly as possible.

ETFs provide individual investors with a way to lock in market 
returns while minimizing expense.  ETFs have grown as investors 
become educated about the disadvantages of conventional mutual 
funds. 

Lyle Wilkinson, investor, trader, author, MBA
Helps individuals learn to self direct their stock portfolios.
Book, e-book, PowerPoint "DIY Portfolio Management”
http://www.diyportfoliomanagement.com
mailto:joe@diyportfoliomanagement.com