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Although existing exchange-traded funds each track a particular index, they are not all created equal. How an ETF is structured can have subtle effects on its performance in the short term. For long-term investors, even these slight performance discrepancies can have important consequences, and it's been said that indexing is a "game of inches."
Today all ETFs come in one of two structures: unit investment trusts and management investment company. Merrill Lynch's HOLDRs, which are not considered true ETFs by most analysts, are grantor trusts.
Some of the first and largest ETFs were structured as unit investment trusts (UITs), including the SPDR 500 (AMEX:SPY), Dow Jones Diamonds (AMEX:DIA), Nasdaq-100 Cubes (AMEX:QQQ), and S&P MidCap SPDRs (AMEX:MDY). The UIT structure was originally selected for ETFs because it was cheap and easy to manage - for example it doesn't require a board of directors.
The Largest ETFs are Unit Investment Trusts
Name
Ticker
Net Assets
% of Total ETF Assets
Rank
S&P 500 SPDR
SPY
$43,438,956,080
36.28%
1
Nasdaq-100 Index Tracking Stock
QQQ
$20,332,254,000
16.98%
2
DJIA DIAMONDS
DIA
$5,848,677,120
4.88%
4
S&P 400 MidCap SPDR
MDY
$4,877,865,300
4.07%
5
Source: The American Stock Exchange
However, UITs do not have the same flexibility of the management investment company, such as the ability to immediately reinvest dividends, lend securities, and use derivatives in managing the portfolio.
Most ETFs have the management investment company, or open-end, structure. This more flexible structure allows for securities lending and enables the funds to be measured against their predecessor mutual funds by rating agencies like Morningstar and Lipper. The open-end ETF manager also has the discretion to immediately reinvest dividends, use optimization techniques to replicate index performance (hold fewer stocks than the benchmark), and use futures and options.
Generally, the UIT structure is well suited to highly liquid large-cap indexes. The open-end structure and the ability to use representative sampling techniques are more critical when tracking small-cap or less liquid benchmarks, since holding every stock in the index is prohibitively expensive.
The different dividend reinvestment policies for the two ETF structures have resulted in what analysts call "dividend drag." ETFs with the open-end structure can immediately reinvest (equitize) dividends, while UITs cannot. The ability to reinvest dividends results in outperformance in a rising market, and underperformance in a declining market.
However, the effects of dividend drag are so small - only a few basis points per year - that most investors probably won't even notice, at least in the short term.
There are two ETFs with different structures that both track the S&P 500. The iShares S&P 500 (AMEX:IVV) has the open-end structure, while the first and largest ETF, SPDR 500 (AMEX:SPY), is a UIT. The iShares S&P 500 was introduced in 2000 in bear market.
ETF
2001
2002
YTD (as of 6/13/03)
SPDR 500
-11.83%
-21.54%
12.80%
iShares S&P 500
-11.94%
-21.91%
12.60%
Source: Morningstar
It will likely take several more years of data before any meaningful conclusions can be drawn from this head-to-head comparison.
However, ETF dividend drag may soon become a moot point. According to the website www.etfconnect.com, at least one of the trustee-custodians of the UIT structure ETFs has applied to the SEC for permission to take the steps necessary to equitize dividends and engage in stock lending.
With the number exchange-traded funds rising, more investors are becoming aware of the trading strategies associated with sector ETFs. These baskets of stock can minimize the hazards associated with owning individual equities, allow you to take short positions and make long-term bets. But some experts think sector ETFs are riskier than they appear.
Investors have used actively managed sector funds for many years to target market segments, from technology to energy and utilities, but expenses for such specialty funds have tended to be high. The low cost of indexing, and of ETFs in particular, is part of what makes these newer funds so appealing to institutional and individual investors alike.
You can collect several sector products for a diversified portfolio, or you can buy just one in order to play a theme, said Dan Dolan, director of wealth management strategies for Select Sector SPDRS, which divides the nine sectors of the Standard & Poor's 500 into ETFs. For investors looking to participate in trends, but disinclined to conduct the sort of deep analysis needed to make smart individual stock purchases, sector ETFs are an easy solution., he said.
"I want to be able to sleep at night, and I want stable growth without having a stock blow up in my face," Dolan said. "The ETF, the sector ETF, gives you more stability. It does everything an individual stock would do, with more diversification. And if I'm right about the concept, it will perform well."
Bad news can easily sink a stock, a point underscored recently when dangers associated with painkillers sent shares of Merck & Co. and Pfizer Inc. on a rollercoaster ride. When even blue chips like these are vulnerable, it makes sense to spread out risk with an ETF, Dolan said, particularly when you're looking to invest in an idea, rather than an individual stock.
"If you think the price of oil is going to stay where it is, all of these oil companies will benefit," Dolan said. "If you believe in the aging demographics in this country, and that more money will be spent on healthcare, being right about an individual stock may not be as important as being right about the concept."
Unlike traditional mutual funds, ETFs are traded intraday, like stocks, so another way investors might use sector ETFs is to sell them short, said Gus Sauter, chief investment officer of the Vanguard Group, which offers 10 sector funds among the 23 ETFs in its VIPERs series.
For example, suppose you work for Exxon Mobil Corp., and your company stock makes up an uncomfortably large portion of your portfolio; one way to diversify without selling and paying capital gains is to short the whole energy sector. When you short, you're betting that the security you're investing in will fall. In this case, shorting the sector would serve as a hedge against your large stake in company stock. But like all investments, ETFs are best used as part of a broadly diversified, balanced, long-term strategy, Sauter said.
"We don't think people should place big bets on them," Sauter said. "So many invest by looking in the rear view mirror. We take a more cautious approach. We do believe there are some advantageous uses of sector ETFs. But people who try to move around, chasing after what did well over the last two or three years, that's a recipe for getting burned."
With so much proliferation of product in the industry, there are now a number ways to invest in sector ETFs -- through SPDRs, through Vanguard's VIPERs series, which track Morgan Stanley Capital International indexes, and the iShares series from Barclays Global Investors, which follows Dow Jones indexes, among others.
From the perspective of small investors, the principal difference between these is cost. Vanguard's sector VIPERs are the cheapest, with recently reduced expense ratios of 0.25 percent. The SPDRs are close behind, with an average expense ratio of 0.27 percent, while iShares charges about 0.60 percent, partly to cover marketing costs. But the fees don't tell the whole story, said Dan Culloton, an analyst with fund tracker Morningstar Inc.
"You want to look at the underlying indexes and how well they capture the return of the market segment they're trying to track," Culloton said. "Construction matters, cost matters, and management matters. The ability of a manager to track an index, to reduce tracking errors, to manage taxes, all play into the quality of an ETF."
Because all sector ETFs are cap-weighted -- meaning the largest stocks in the basket have the most influence over performance -- they often are closely correlated. But the number of stocks an ETF holds can have an impact on returns, Culloton said. A more diversified fund might be less bumpy than one that's less concentrated; you might get a better yield out of one and no yield at all out of another.
For example, the energy SPDR (XLE) has 28 holdings; the top two, Exxon Mobil and ChevronTexaco Corp., account for more than 35 percent of its weighting, and the top 10 stocks combined make up 66 percent. By comparison, the energy VIPERs (VDE) has 122 stocks, with 60 percent of its assets in its top ten holdings, led by Exxon and Chevron. This illustrates the biggest risk associated with sector ETFs, Culloton said: the danger of being overly concentrated in just a handful of stocks.
"I think sector ETFs are a very dangerous and potentially very expensive toy that most people could do without," Culloton said. "If the average professional money manager can't beat the market, what are the chances of the average individual investor beating the market? The best way to capture gross returns, as much as you can, is to buy a broad-based fund and hang onto it forever. Buy and hold is boring, but it's effective in the long run."
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