Point of View

Many investors are drawn to index-based investment programs as an efficient way to gain market exposure, or beta. Building on that trend, many investors are turning to exchange-traded funds (ETFs) for their index-based portfolios because of the advantages ETFs offer over other forms of index-based investment products.

Shares of an ETF — which represent equity ownership in a portfolio designed to track an underlying benchmark through replication or optimized techniques — trade throughout the day on securities exchanges. Although similar to mutual funds, ETFs generally have lower costs, are transparent and can be sold short and bought on margin. Perhaps most important, ETFs often benefit from reduced portfolio turnover and other tax efficiencies, yielding advantages for tax-exempt or tax-deferred accounts.

According to the Investment Company Institute, U.S.-listed ETF assets totaled more than $608 billion as of December 2007, a 44% increase during the previous 12 months. During that period, domestic equity ETFs increased $103.1 billion and global equity ETFs assets rose $68.5 billion. Morgan Stanley projects worldwide ETF assets will exceed $2 trillion by 2011. “For many investors, an ETF can be the most efficient and effective investment vehicle for indexed-based programs,” says Peter K. Ewing, managing director of the ETF group at Northern Trust. “These products appeal to a broad spectrum of investors and investment professionals, including individual investors and their financial advisors, pension plans, mutual funds, hedge funds, foundations and endowments.”

Another indication of the funds’ growing popularity is that ETF trading volume was 100 billion shares in 2006. That volume is about the same as all New York Stock Exchange trading in 1996, according to Gary Gastineau, principal of ETF Consultants LLC in Summit, N.J. “Recent volume has been running more than one billion shares per day,” he notes. “There’s something going on here other than investors wanting to do something interesting with fund investments. Most of this trading volume is because ETFs can be used for risk management purposes by hedge funds, by broker dealers and occasionally by mutual funds. For some investors, [ETFs] can be more beneficial than futures for risk management purposes. There also are incentives offered by exchanges to stimulate ETF trading.”

Implementing an ETF Strategy

One of the more popular uses of ETFs is as part of a passively managed index-based investment strategy. “ETFs offer diversified exposure in a one-stop approach,” Ewing says. “[They] are often considered the best available method for gaining single-trade exposure to — in some cases — thousands of stocks.”

Indexing strategies have evolved over the years, with investors seeking to broaden and deepen their portfolios to more accurately reflect a market or market segment. For example, for an investor seeking diversified exposure to one or more foreign stock markets, ETFs can offer a highly efficient set of solutions, ranging from single-market products to regional or global market products. In this way, a combination of ETFs can be used to create a new index-based program or to complement the investments of an existing portfolio to obtain more diversified, comprehensive market exposures.

Similarly, ETFs also can be used to fill style or segment gaps in an overall equity portfolio — whether it’s managed actively or passively — until the appropriate investment manager can be identified.

Another growing trend is to use ETFs as building blocks in a multi-asset investment strategy, with or without target-date properties. For example, allocations to an array of ETFs can be adjusted to address conservative, moderate or aggressive risk profiles. The mix also can be adjusted to recognize other factors that characterize an individual investor’s financial circumstances.

“Different ETFs will be more appropriate for different investors based on their risk tolerances, investment objectives and how the funds fit into existing portfolios,” Ewing notes.

“They can also be good for cash equitization, where a manager has cash he or she doesn’t know where to put at a particular moment, but nevertheless wants broad exposure to the market in the interim.”

Opportunities for Many Investors

ETFs also are playing a larger role in the portfolios of taxable investors. Tax efficiencies, which have come to characterize many ETFs, are driving this trend.

Each ETF share represents ownership in a basket of stocks or other securities. As its name suggests, ETF shares trade on exchanges. Thus, if one investor wants to buy ETF shares and another wants to sell them, the trade occurs in the open market in transactions that the fund itself never sees.

Not so with a mutual fund. “Traditional open-ended mutual funds often must sell securities to raise cash in order to meet shareholder redemptions, triggering taxable capital gains that must be distributed to shareholders in the form of taxable gains,” Ewing explains. “Because ETF shares trade on exchanges in the secondary market, the interests of buying and selling investors can offset each other. This helps reduce portfolio turnover and distributable gains.”

Shareholders in ETFs also can benefit from their use of in-kind transactions. When an ETF needs to issue or redeem shares, it typically does so in special transactions that involve the delivery of ETF shares against the delivery of portfolio securities. These in-kind transactions reduce cash-based securities trading, which, in turn, often means advantages for tax-sensitive investors in the form of fewer distributable gains.

But tax-related efficiencies represent just one of several advantages offered by the ETF format. Others benefits include opportunities for reduced index tracking error, lower fund operating expenses and intra-day trading.

Access to International Markets

Investors also are showing increased interest in using indexing in general, and ETFs in particular, as an efficient way to invest in international markets. Although investors are realizing the importance of long-term international exposure, the trend has been accelerated because of the recent strong performance of overseas markets relative to the United States. There also is mounting sentiment around the decoupling of the U.S. and other economies.

Growth in real GDP has slowed in the United States, but has increased in many other countries. Coupled with the declining value of the U.S. dollar relative to most other large currencies, the case for international exposure becomes even stronger.

Still, overseas markets have different regulations and risk factors and, in some markets, obtaining information on specific industries or companies can be difficult. International ETFs simplify the process of gaining exposure to international equities because they are traded on domestic exchanges.

By owning ETFs that seek to track single-market, non-U.S. indices, Ewing says investors can gain “exposure to important markets worldwide. Each product is tied to a benchmark reflecting the performance of a given market and economy.”

All Indices Are Not Alike

One of the most important considerations for investors contemplating an ETF strategy, whether domestic or international, is the composition of the underlying index. Understanding the nuances of each index will help ensure investors get the exposure they want.

For example, the S&P 500 represents about 80% of the U.S. equity market, but because it’s weighted by capitalization, it tends to favor large-cap growth stocks. The Dow Jones-Wilshire 5000 is more inclusive, comprising nearly every publicly traded company in the United States.

Another consideration is whether the underlying index is well known. “The recognition and familiarity of these indices is very important,” Ewing says. He notes that highly visible indices — such as the S&P 500 in the United States — have been selected by investors and capital markets professionals worldwide as representative benchmarks for certain markets.

Similarly, “established flagship local indices such as TOPIX in Japan, DAX in Germany, CAC 40 in France and the FTSE 100 in the United Kingdom display characteristics of greater recognition and liquidity. They are the benchmarks for the most active index futures contracts in their home markets,” says Steven A. Schoenfeld, chief investment officer for the Global Quantitative Management group at Northern Trust. “U.S.-listed ETFs on these well-known indices can help American investors gain efficient exposure to non-U.S. equities and can help global investors extend the trading day on these well-established index products.”

“The fact that many of the indices have liquid futures contracts helps market makers hedge exposure cheaply and efficiently, which in theory should lead to tighter spreads and lower transaction costs for investors,” Schoenfeld adds.

Institutional investors are using ETFs not only to gain market exposure efficiently, but also to construct equity portfolios with greater depth and breadth. As the ETF market continues to expand, in terms of both overall size and the number of offerings, more investors are expected to take advantage of this flexible investment vehicle.

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