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.

The quest for superior performance is also motivating the development of new ETFs and indexes. On May 1 of last year PowerShares Capital Management launched two funds on the ASE, the Intellidex Dynamic Market (PWC) and Dynamic OTC (PWO) Funds. Their portfolios are based on Intellidex indexes developed by the ASE and licensed to PowerShares. According to the ASE, "The Intellidex Indexes consist of securities that meet objective screening criteria. [They] are designed to identify stocks that have capital appreciation potential using a proprietary stock selection and portfolio construction methodology."

PowerShares' performance is also promising, and is likely to inspire further attempts at launching ETFs that outperform the benchmark averages. PWC and PWO have outperformed their respective benchmarks since began trading. PWC has a total return of 43.6%, 18% better than the S&P 500's 25.6%, with a slightly higher annualized standard deviation of 9.1% versus 7.6% over its first ten months. PWO's 56.8% total return outperformed the Nasdaq Composite's 48% over the same period with a 27.1% annualized standard deviation that more than doubled the Nasdaq's 12.7%. Following the success of these ETFs, PowerShares Capital Management licensed six additional Intellidex indexes for use in ETFs: growth and value indexes for large-, mid-, and small-cap stocks.

Applications For Controlling Risk

The trend towards building ETFs to achieve superior performance is expected to intensify, and for good reason. If ETFs can be created to routinely provide an incremental return above their benchmark indexes while closely tracking them, a variety of profitable market-neutral strategies could be devised. Many experts believe that the next stage in the evolution of ETFs will involve enhanced index funds (EIFs), funds designed to replicate the volatility of a benchmark index but provide an excess return above it.

To illustrate their primary advantage, assume an EIF in the form of an ETF could produce an annual return of 2% above Standard & Poor's Depository Receipts (SPDR) while tracking it, and that it existed on January 28, 1993, the SPDR's inception date. An initial long position of $100,000 would have grown to $368,715 by December 31, 2003. A similar long position in the SPDR would have grown to only $301,731 or $66,984 less.

Alternatively, a long position in the EIF could be hedged against a short position in the SPDR to create a market neutral strategy that captures its excess return with minimal risk. Furthermore, the strategy could be leveraged to produce a multiple of the EIF ETF's excess return less the costs of borrowing the shorted SPDR and the funds used for leverage.

Currently, market-neutral strategies are in great demand among hedge funds, arbitrageurs and other institutional investors as a means of profiting while controlling risk. These strategies can be leveraged to a level yielding returns above a hedge fund's management fees while reducing its exposure to market risk.

Since the holding period for strategies using ETFs is indefinite, arbitrageurs can maintain positions without concern for roll periods, as in the case of futures, or expiration dates, as in the case of options. The asset gathering potential for ETFs that can be used in such strategies is enormous and, therefore, very likely to spur their development.

The use of leverage to enhance an ETF's performance may soon become a reality. ProFunds, a Bethesda, Md.-based mutual fund family, has filed for Securities & Exchange Commission approval to sponsor several leveraged ETFs. Since ETFs trade like stocks, they have been eligible for margin trading all along, permitting the use of margin debt for leverage. What is unique about ProFunds' planned use of leverage is that it will be imbedded in its ETFs.

Perhaps the most under-represented asset class among ETFs is fixed income. At this writing, there are only five fixed-income funds, all sponsored by iShares: three based on Lehman Bothers Treasury Indexes with maturities of one to three, seven to ten and 20-plus years; one on the Lehman Aggregate Bond Index, and the last on Goldman Sachs' $InvesTop Corporate Bond Index. Barclay's Global Investors seems intent on increasing that number, as iShares recently filed for two additional fixed-income funds, one using Treasury Inflation Protection Securities and another using high-yield bonds.

Supporting Developments In Financial Services

ETFs' popularity is also gaining momentum as a result of three seemingly unrelated industry developments. First, advisors have been moving rapidly toward fee-based compensation in the last five years in their desire for more predictable income streams. Fee-based advisors tend to use ETFs instead of mutual funds due to the ease with which diversified portfolios can be built and rebalanced, in addition to their other advantages. As the number of fee-based advisors grows, so will the assets invested in ETFs. Commission-based advisors normally shun ETFs in favor of mutual funds to capture their higher sales charges.

The second supportive development relates to a recent breakthrough in investment technology that greatly simplifies the process of identifying client risk/return preferences and objectives and designing optimal asset allocations to meet them. It also offers a simple test for determining when rebalancing is required. This new technology, known as "resampled efficiency," has been patented by Richard and Robert Michaud of New Frontier Advisors, a Boston-based firm. It increases the probability of maintaining or even increasing a portfolio's returns while reducing its costs. The technology employs simulation techniques to identify a "true" efficient frontier and to avoid the singular asset allocation solutions found in classical mean-variance optimization methods. It is particularly useful in designing purely ETF portfolios that achieve higher returns at specified risk levels while reducing rebalancing costs.

Harry Markowitz, the economist who won a Nobel Prize for his contribution to modern portfolio theory, recently tested resampled efficient optimization and classical mean-variance methods and published his findings in the Journal of Investing in January. He found that resampled efficient optimization methods produce more diversified and stable portfolios with statistically significant higher returns in ten out of ten cases.

Lastly, recent scandals concerning late trading in some mutual funds has made investors aware that certain individuals were allowed to benefit from knowledge of price changes in some securities to the detriment of the funds' shareholders. The vast majority of investors were unaware that such activities were possible, much less taking place. Many investors and regulators alike are outraged at the privileged treatment accorded those individuals, with some believing the offending mutual funds did not take adequate measures to prevent those abuses.

ETFs are not vulnerable to the same late trading activities because only authorized participants can make transfers into and out of an ETF, and this must be done during trading hours. Also, an independent distributor authenticates their trades. Investors wishing to avoid prospective losses due to late trading in mutual funds by unscrupulous individuals are, therefore, advised to confine their investments to ETFs.

C. Michael Carty is founder of New Millennium Advisors, an investment advisory firm in New York City that manages pension plans and individual accounts and often utilizes ETFs. He can be reached at [email protected].