New ETFs are being created as strategies and technology are developed.

Exchange-traded funds (ETFs) are the fastest-growing investment products in U.S. financial markets today. They are portfolios of securities designed to generally track stock or bond market indexes, with shares that trade intraday on an exchange at market-determined prices. In fact, they are sometimes described as mutual funds that trade like stocks. Investors can buy or sell ETF shares through a broker just as they would the shares of any publicly traded company.

Since ETFs trade continuously at prices very close to their intraday indicative values (proxies for NAVs), they are unlike closed-end funds, which ordinarily trade at prices different than NAV, usually at a significant premium or discount.

Why Are They Important?

The popularity of ETFs is growing rapidly as are their assets. Between their inception in January 1993 and year-end 2003, total assets in ETFs traded domestically grew to $151 billion by, a 78.3% annual growth, and their number increased to 119.

Equity-indexed ETFs frequently outperform the majority of actively managed equity funds, have lower turnover, give investors more choices of entry and exit prices, smaller management fees, reduced expenses, transparency and greater diversification. Also, they are not prone to "style drift," the tendency of active managers to depart from their avowed investment styles in the quest for greater returns. In fact, once fees and taxes are taken into account, more than 75% of active large-cap fund managers fail to equal the performance of the S&P 500 index over most five-year periods.

ETFs have a unique operational structure, which allows them to mitigate or possibly avoid capital-gains distributions. The shares of an ETF are created by institutional investors authorized to transfer a basket of securities, called a "creation unit," equivalent to a portion of its underlying portfolio, in exchange for a block of the fund's shares, usually 50,000. Shares are redeemed by institutional investors authorized to transfer blocks of 50,000 shares back to the fund in exchange for a basket of securities, called a "redemption unit," in the portfolio. This "in-kind" creation/redemption process is made with securities rather than cash, so no taxable event takes place. This unique feature makes ETFs more tax efficient than the vast majority of mutual funds.

ETFs also offer investors an impressive variety of asset classes. By the end of 2003, there were 18 asset classes including large-, mid- and small-cap funds, growth and value funds, sector funds, international and fixed-income funds, with numerous choices within those classes. Although ETFs are passive investment vehicles, they are ideal tools for implementing such active strategies as over- or underweighting certain market segments in an attempt to beat benchmark averages or contain risk to a desired level.

Advisors can use ETFs to achieve five principal objectives: 1) acquiring the proper asset allocation for implementing a long-term portfolio strategy with a minimal amount of operational complexity and projected rebalancing costs; 2) making short-term tactical portfolio adjustments to gain or reduce exposure to a particular market segment, style or sector, again with minimal operational complexity and cost; 3) achieving or maintaining an asset allocation target during account transfers; 4) quickly converting a large influx of cash into equities or bonds; and 5) reducing exposure to an overweighted risky position by shorting one or more ETFs to meet a targeted allocation.

Where Are They Going?

Considering their explosive growth and broad applications, what's next in the evolution of ETFs? As useful as index-linked ETFs are, one wonders if the United States is saturated with ETFs based on the most popular indexes. Do investors and their advisors need more indexes? Aren't we approaching diminishing marginal utility with the next one?

Apparently not, since new indexes and products based on them continue to be offered. Just this year, on January 23, iShares listed the S&P 1500 Index Fund on the American Stock Exchange (ASE), to provide a means of investing in the broad U.S. market. A week later, Vanguard listed on the ASE 14 VIPERS based on equity indexes built by Morgan Stanley Capital International. They include seven style funds: growth, value, large-cap, mid-cap, small-cap, small-cap growth and small-cap value; and seven sector funds: consumer discretionary, consumer staples, financials, health care, information technology, materials and utilities.

Performance-Oriented Products

Getting new life out of established indexes is also in vogue. Standard & Poor's, in collaboration with Rydex Global Advisors, created an equally weighted index of the same component stocks as the capitalization-weighted S&P 500. The Rydex S&P Equal Weight Index began trading on the ASE a year ago and is rebalanced quarterly to maintain its equal weighting. It provides broad exposure to S&P 500 companies without being dominated by a small group of the largest stocks in the index. Also, its periodic rebalancing feature appeals to many advisors. Since inception, the fund's total return is 48.8%-23.8 percentage points greater than the cap-weighted S&P 500 Index's 25%-a promising beginning-despite the fund's somewhat higher annualized standard deviation of 11% versus 7.6% over its first ten months.