Exchange-Traded Funds

Investment Snapshot

* As of October 2006, there were 315 ETFs in the United States, of which 309 were stock ETFs (www.ici.org).
* The number of ETFs on the market grew by 57 percent for 10 months of 2006.
* ETFs are traded on the stock markets and not through investment companies.

Exchange-traded funds (ETFs) are baskets of stocks or bonds that track a broad-based index, sector of an index, or stocks in countries. ETFs are similar to closed-end mutual funds in that investors buy these listed shares on the stock exchanges. The predominant listings are on the American Stock Exchange (AMEX). These shares represent ownership in a portfolio of stocks or bonds that track a broad index or sector indexes. Investors buy or sell these shares through brokers just like they do with individual stocks. ETFs are priced based on the types of securities that they hold in addition to the supply of and demand for the shares. These shares can be sold short or bought in margin accounts, and they can be traded using market, limit, or stop orders.

The greatest competition to mutual funds has come from ETFs. ETFs have become popular investment alternatives to mutual funds for many investors who want diversification and low-cost investment options. The typical costs charged to investors in equity ETFs are 0.4 percent of assets annually compared with 1.4 percent of assets for the average equity mutual funds, according to Standard & Poor’s (Young, 2004, p. 124).

There are over 300 ETFs to choose from; this number has grown significantly since the first ETF, the Standard & Poor’s (S&P) Depository Receipts (known as Spiders) was introduced in 1993. Table 16–1 lists a few of the many ETFs traded on the market. Some of the more popular ETFs are the SPDRs (Spiders) that track the S&P 500 Index; Diamonds, ticker symbol DIA, that track the 30 stocks in the Dow Jones Industrial Average; and the Qubes, ticker symbol QQQQ, that track ownership in the 100 largest stocks on the Nasdaq. There are numerous ETFs that are specialized in sectors of the broad indexes (financial, technology, and industrials, for example) and in foreign stock market indexes [i Shares, which tracks the Morgan Stanley Capital International indexes (MSCI) for 20 countries and many regional sectors around the world]. Visit the AMEX Web site at www.amex.com for information on the various ETFs listed. See Table 16–2 for a description of spiders, diamonds, and the Nasdaq 100 tracking stock.

Name	Ticker Symbol	Category/Index
SPDRs Diamonds Nasdaq 100 Trust iShares MSCI EAFE Index Semiconductor HOLDRs BLDRS Asia 50 ADR BLDRS Europe 100 ADR iShares Lehman TIPS Bond Pharmaceutical HOLDRs Financial Select Sector iShares Russell 2000 iShares MSCI Spain	SPY DIA QQQQ EFA SMH ADRA ADRU TLT PPH XLF IWN EWP	S&P 500 Index (large-cap) Dow Jones Industrial Average (large-cap) 100 Largest stocks on Nasdaq International index (large-cap) Semiconductor stocks Pacific/Asia stocks European stocks Inflation government bonds Pharmaceutical stocks Financial stocks in S&P 500 Index Small-cap stocks in Russell 2000 Index Spanish stocks

Table 16-2
More About Spiders, Diamonds, and Nasdaq 100 ETFs
There is a family of ETFs that is based on the S&P 500 Index and its component sectors, such as technology, energy, and financials, for example. The SPDR Trust holds shares of all companies in the S&P 500 Index. The purchase of a single share in this trust gives its owner a share of the 500 companies in the S&P 500 Index. Several select, specialized SPDRs allow investors to track, for example, the financials in the S&P 500 Index or the 79 tech stocks in the S&P 500 Index. Investors also can track the utilities, industrials, and five other sectors in the S&P 500 Index. These sector ETFs are traded just like the main SPDR (SPY).
The ETF that tracks the 30 stocks of the Dow Jones Industrial Average (DJIA) is called a Diamond (DIA). The purchase of a single share in this fund gives its owner a share of the 30 DJIA stocks.
The ETF that mirrors the 100 largest stocks in the Nasdaq is called a Qube (QQQQ). The purchase of a single share in this ETF gives its owner a share of these Nasdaq 100 stocks.
Following is a list of some of the features of these ETFs:
Trading. These ETFs are traded on the AMEX.
Approximate share price ratio. The values of shares of a Spider, Diamond, and Qube ETF in relation to the respective indexes tracked are 1/10 the value of the S&P 500 Index for 1 SPY share, 1/100 the value of the DJIA for 1 DIA share, and 1/20 the value of the Nasdaq 100 Index for 1 QQQQ share.
Dividends. Dividends are paid quarterly (in January, April, July, and October) Risks. The risk for these ETFs is the same as experienced by individual stocks, namely, price fluctuations. There is also the additional risk that the fund may not replicate the exact performance of the underlying index because of expenses incurred by the fund.
Net asset value. The NAV per ETF is calculated at the close of each business day. The value represents the market value of the stocks in the underlying index, plus any accrued dividends and minus any expenses on a per-share basis.
Short selling. Investors can sell short these ETFs and on a downtick.

The description of the net asset value (NAV) implies that the share price of an ETF can trade above or below its NAV. This discrepancy generally will not occur because of the issuance by the ETF of shares in kind. Whenever a discrepancy in price occurs and an institutional investor wants to exploit this price differential with large blocks of shares (a minimum of 50,000), the ETF trust redeems the shares with the underlying stocks in the index rather than paying cash. The institutional investor then sells the shares of the underlying stocks in the index, not the shares of the ETF, to realize the price discrepancy. This concept emphasizes the similarities between open-end mutual funds and ETFs. An ETF buys and sells shares and issues new shares when necessary. However, ETF investors can buy or sell shares at any time during the day on the stock exchanges, whereas transactions involving open-end mutual funds take place only at the end of the day at the closing NAV price. The major difference between an open-end mutual fund and an ETF is that when shareholders in mutual funds sell their shares, the mutual fund may have to sell securities to raise enough cash to pay shareholders, resulting in capital gain or loss transactions. With ETFs, traders buy the shares sold by investors, and this leaves the portfolio intact.

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