A New Breed of ETF

10/06/2006 12:00 am EST

Focus:

Janet Brown

Editor, NoLoad Fund*X

Mutual fund expert Janet Brown gives a detailed overview of the exchange-traded funds market, compares their characteristics to that of traditional mutual funds, and introduces readers to a new genre of ETFs sure to command investor interes.

 

"Although exchange-traded funds (ETFs) are relatively new, they are already evolving to meet a broader array of investor needs. The first ETFs offered broad index representation including the S&P 500 index, Dow Jones, NASDAQ 100 and access to individual countries as represented by the various MSCI world indexes. As ETFs grow more popular, more segments become available. Investors can now replace almost any traditional index fund with a comparable ETF. This includes value and growth indexes of all market capitalizations, foreign markets including emerging markets, and even commodities.

 

"Structurally, ETFs are mutual funds, but ETFs differ primarily in two ways: 1) How they trade: ETFs are priced and traded throughout the day, and 2) How they are managed: Most traditional funds are actively-managed with a fund manager who selects stocks for the portfolio, while most ETFs are passively-managed and mirror a specific index. The newest ETFs, however, are more like actively- managed funds. Most indexes and the ETFs that track them are market cap-weighted, meaning that the largest companies get the greatest representation in the index.

 

"But new ETFs are offering access to other index selection methods, making these ETFs more like actively-managed funds. Examples include an equally weighted S&P 500 index fund where each company has the same impact on the fund regardless of size, and a variety of new ETFs whose components are chosen by quantitative screens. The newest ETFs are known as fundamentally-driven because they select securities and portfolio weightings based on fundamental screens. Offerings include companies with relatively high earnings growth, or relatively low valuations. Some ETFs now begin with traditional indexes and simply re-weight the index holdings based on characteristics such as the highest dividend payers. Screens are used to define new indexes that are then packaged into ETFs. Active fund managers often employ similar filters when selecting stocks for their fund's portfolios.

 

"The difference between an active fund manager and ETFs that recreate indexes is that active managers try to add value by uncovering new information that might change (either improve or diminish) a company's standing, while current ETFs only screen companies based on reported data. Many academic studies demonstrate the challenges a fund manager faces to discover useful new information, and attribute most of thelong-term performance of active managers to portfolio construction (which is essentially, the use of screens). Remember, at the end of the day it is performance that matters."

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