The ABCs of ETFs

Suddenly, everyone's talking about exchange-traded funds. Are they right for you?

ETFs offer all the flexibility of stocks: They're priced throughout the day; can be purchased with market, limit or stop-loss orders; can be shorted; and can be traded on margin. And as with stocks but unlike mutual funds, there are put and call options based on many of them.

Because ETFs are passively managed and don't have much asset turnover, their expense ratios are far lower than those of even the most cost-efficient actively managed funds. They're even lower than those of most passively managed index funds. For example, the first-ever ETF, Standard & Poor's Depositary Receipts (SPY), known as Spiders, carry a lean and mean expense ratio of 0.11%. Barclays iShares S&P 500 Index (IVV) is even lower at 0.09%. Not even Vanguard 500 Index's (VFINX) incredibly cheap 0.18% can beat those.

Sure, a few hundredths of a percentage point is negligible. But consider the differences among sector investments. The relatively low-cost Rydex Financial Services fund (RYFIX), for example, has an expense ratio of 1.38% -- far greater than the Financial Select Spider fund's (XLF) expense ratio of 0.27%. Comparing a $10,000 investment in each, and assuming a 10% annual return, the Rydex fund would see $899 eaten up by fees in five years, and $2,250 in 10 years. The ETF would sacrifice only $180 in fees in five years' time and $467 over 10 years.

Mind you, index ETFs don't always outperform their index mutual fund counterparts. For example, from 1994 to 2002, Spiders, which track the S&P 500, delivered a cumulative return of 119.52%, a hair shy of the Vanguard 500 Index's 120.69% gain. Why the discrepancy? ETFs tend to be even more passive in implementing index changes than their mutual fund competitors. But some ETFs are nimbler than others. The iShares S&P 500, for example, beat the Vanguard 500 in 2001 and 2002. Last year Vanguard nudged ahead by a nose.

Extreme passivity can have its advantages. Perhaps the biggest selling point for ETFs is their tax efficiency, which can be substantial. Because of their structure, ETFs protect shareholders from the downside of investor churn: Capital gains distributions aren't triggered for every investor whenever a position is sold — a boon come tax time. Of course, if an individual investor sells an ETF and realizes a gain, it will be taxable. But while incremental trading costs are the collective responsibility of most mutual funds' shareholders (and arguably borne to a greater extent by long-term investors), ETF investors simply pay their own way.

Van Siler, 54, of Summit, N.J., was especially drawn to the tax benefit. "The biggest difference to me is the tax efficiency," he says. "You're in control of whatever the consequences are."

That doesn't mean, however, that capital gains are never an issue. Back in 2000, when the major indexes touched all-time highs and then plummeted, mutual funds of all types were forced to unload stocks as investors bailed out, triggering capital gains bills for the investors who hung on, even as ETF values fell. In that year, 27 ETFs (about a third) issued capital gains. But increasingly sophisticated techniques to manage distributions have kept a lid on distributions more recently. During rollicking 2003, just three of the 112 ETFs tracked by Lipper distributed capital gains. Spiders haven't distributed capital gains since 1996.

The biggest drawback for ETFs is transaction costs. The only way to buy or sell an ETF is via a broker -- and for fast-fingered traders, the costs can add up. That's why fans of dollar-cost averaging might find ETFs to be a pricey endeavor.