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Exchange-traded funds may help you sleep at night

Investors who are looking for a haven from stock market gyrations and corporate shenanigans sometimes shift from single stocks to mutual funds. But mutual funds can be weighed down with fees, short-term trading restrictions and scandals of their own. Exchange-traded funds are an alternative that many people have been finding attractive. They're most often touted for their low cost, tax efficiency, transparency and liquidity.

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ETFs have been around since the early 1990s, but seem to have caught fire the past couple of years. According to data published by Investment Company Institute, the combined assets of the nation's ETFs in March 2003 were just over $100 billion. One year later, that figure stood at $161 billion; by March 2005 it had ballooned to $228 billion.

There's a similarity to mutual funds in that each ETF contains a basket of stocks that have something in common. Currently, ETFs are based on indexes focusing on everthing from the S&P 500, to real estate, gold and other precious metals, and even China's top 25 companies.

"ETFs have become the perfect companion for the do-it-yourself investor," says David Fry, publisher of ETF Digest. "The fees are low; it's easy to get in and out. There's tremendous variety and liquidity."

The price you pay for a share of an ETF fluctuates throughout the day. You buy shares on the market just as you do with stocks. Mutual funds, on the other hand, can only be traded once a day at the price set at the end of the trading day.

Even though you can trade ETFs like stocks, some financial advisers discourage that.

"Most people don't have the discipline to maintain a diversified portfolio," says certified financial planner Bruce Brinkman of Timothy Financial Counsel in Rockford, Ill.

"They're in and out, and that's one of the drawbacks of the ETF philosophy. People are tempted to get in and out because you can trade them so quickly. They're working against themselves thinking they can time the market and get ahead of the trend. Very few succeed at that. You can't do that with mutual funds. The regular index mutual funds have worked well for the buy-and-hold crowd. They get their allocation set and keep it until there's some reason to change, but they're not making quick changes."

Some companies, such as David Fry's ETF Trader, specialize in using market timing to buy and sell ETFs. But that type of trading is best done with professional guidance.

The tax efficiency of ETFs stems from that fact that they're not actively managed. Only rarely are shares of the underlying stocks that make up a fund sold. That means there are few, if any, capital gains distributions that trigger taxes for shareholders. You'll pay taxes when you sell shares, if they've appreciated. That's a far different situation from mutual funds where you may have to pay capital gains taxes even if you haven't sold any shares.

"In 2001 and 2002, thousands of mutual funds had losses but distributed capital gains to their shareholders," says William Suplee, CFP and president of Structured Asset Management in Paoli, Pa.

"There were really egregious ones with 40-percent to 60-percent losses, and the investors had to pay capital gains tax. If you invested $50,000 in a fund and lost $20,000 and got a $5,000 tax bill, your head would just explode."

Be aware that just as with stocks, you'll pay a commission every time you buy or sell an ETF. If you want to buy an index fund and periodically add more shares to your holdings, it would probably be cheaper to stick with a no-load index fund. Also, ETFs don't have automatic dividend reinvestment. If you want to reinvest the dividends you'll have to buy additional shares on the market -- and pay a commission.

ETFs also have an expense ratio just as mutual funds but, generally, it's very cheap compared to stock funds and index funds.

Average annual expense ratio
Equity funds1.546%
Index funds0.963%
Source: Lipper
-- Posted: June 7, 2005




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