An Education in ETFs

What are Spiders and Diamonds, and where can I buy them?

QUESTION: What are Spiders and Diamonds, and where can I buy them?

ANSWER: Despite their exotic nicknames, Standard & Poor's Depositary Receipts (SPY) (known as SPDRs or Spiders) and Diamonds (DIA) are simply indexed investments that track the S&P 500 index and Dow Jones Industrial Average, respectively. Spiders and Diamonds are part of the increasingly popular stable of financial products known as exchange-traded funds, or ETFs.

ETFs are open-end mutual funds or unit investment trusts that trade just like stocks. While traditional mutual funds are priced once each day at 4 p.m., ETFs are priced continuously throughout the trading day. Spiders were the first ETFs, launched in 1993 on the American Stock Exchange. Nine years later, some $80 billion is invested in more than 100 ETFs, according to the Investment Company Institute -- and more are on the way. The Cube, or the Nasdaq-100 Trust (QQQ), which tracks the Nasdaq 100 and is traded on the Amex, is the most actively traded ETF, but everyone from Barclays (BCS) to State Street (STT) is trying to unseat the Cube with high-profile ETFs of their own. Even fund giant Vanguard is in on the act. It offers two ETFs called Vipers based on the Wilshire 4500 and 5000 indexes.

The benefits of ETFs are their lower costs and greater tax efficiency compared with most mutual funds. For example, while the Vanguard 500 Index fund (VFINX) costs an already low 0.18% in annual fees, Spiders cost just 0.12% and the Barclays iShares S&P 500 (IVV) costs just 0.09%. And when it comes to taxes, ETFs are insulated from investor churn, since managers aren't forced to sell their underlying stocks to meet shareholder redemptions, prompting huge capital-gains distributions, as is the case with mutual funds.

Of course, this isn't to say that ETFs never issue capital gains -- a common misperception when ETFs were gaining popularity several years ago. In 2000, iShares MSCI Canada (EWC) and iShares MSCI Sweden (EWD) each issued distributions of more than 18%. Why the big bill? These ETFs held more than 25% of their assets in a single stock, which is against Internal Revenue Service rules for mutual funds (including ETFs) -- so they were forced to sell shares to conform with the regulation.

A potential downside of ETFs is that, like stocks, they must be purchased through a broker, which means you'll face commission costs -- unlike buying a no-load fund. One way to cut costs is to use a discount broker. But before you jump in, consider whether the commission route will eradicate the lower-fee benefits of ETFs. For example, if you want to employ dollar-cost averaging and plan to invest monthly, you're probably better off with a no-load mutual fund than an ETF.

Investors should also tread carefully among the various sector-based ETFs out there, since many of these are not based on indexes but instead a sampling of those benchmarks, often resulting in a much narrower sector bet. (For more on that, check out, "The Trouble with ETFs.") Just as with a traditional mutual fund, you should examine an ETF's holdings before investing. For a complete list of ETFs available through the American Stock Exchange, go to its Web site.

Bottom line? ETFs continue to gain popularity, particularly among financial planners. "They are a core part of our portfolio in the way that we were previously using index funds, except they're better in terms of taxes and cost efficiency," says Norman Boone, certified financial planner and president of Boone Financial Advisors in San Francisco. We second that thought.