A cautionary tale of Spiders, WEBS, Diamonds and Cubes

FAQ on Index Share Products [American Stock Exchange]

One of the hottest forms of investing these days is exchange-traded funds.

But even though financial planners are using them with some of their clients,

ETFs are not for everyone.

Exchange-traded funds — sometimes called index shares — are a hybrid of

index mutual funds and stocks. Like index funds, ETFs track a particular

market index by holding the stocks of that index.

Spiders, nicknamed SPDRs, or Standard & Poor's Depository Receipts,

track the S&P 500 index, and perform very much like the C fund in the

Thrift Savings Plan. Diamonds track the Dow Jones Industrial Average, Cubes

follow the Nasdaq 100, and WEBS (World Equity Benchmark Shares) track the

stocks of individual foreign nations. In addition, dozens of new exchange-traded

funds are being added that track other indexes and sectors of markets. Also

like index funds, some exchange-traded funds will reinvest dividends.

Dennis Filangeri, a certified financial planner in Metairie, La., notes

that unlike index mutual funds, ETFs trade like stocks. Spiders, for example,

trade on the American Stock Exchange under the ticker symbol SPY. Like any

stock, the price of an ETF moves up and down during the day, while mutual

fund shares are priced at the end of the market day. You can sell an ETF

short, buy on margin or set limit orders — all tactics you can't use with

an index fund.

Filangeri likes ETFs for several reasons. Perhaps the most attractive feature

is the tax advantages. One of the problems with any type of stock mutual

fund is that the fund generates capital gains through the buying and selling

of stocks, thus creating a tax liability for shareholders. This is especially

a problem during a down market when shareholders may force the sale of holdings

through heavy redemption demands. These tax liabilities aren't a problem

for funds held inside tax-favored accounts such as individual retirement

accounts and retirement plans, but they can be a big issue for any taxable

account.

But ETFs don't buy and sell stocks, except to replace a stock that has been

replaced on an index. Readjustments might generate small capital gains for

investors, but generally the main tax liability investors will face is when

they sell ETF shares for a gain. ETFs could even be bought and sold to offset

other investment tax liabilities. This control of tax liability has long

been the attraction of owning individual stocks instead of funds. But many

investors can't afford to buy enough different stocks to be well-diversified.

ETFs solve that problem because they track all the stocks in their index.

Another attraction of ETFs is that they are usually cheaper than corresponding

index mutual funds. This is offset somewhat by brokerage fees, because ETFs

must be bought through a broker like any stock, but the fees shouldn't be

a big problem if you don't trade ETFs often.

Some of the same features that make ETFs an attractive substitute for index

mutual funds can also make them inappropriate for some investors, Filangeri

said. For example, because ETFs are stocks, investors may be more prone

to try to time trades. Mutual fund investors are less likely to watch the

markets minute by minute or make trades as often as stock traders. Not that

ETFs can't be invested in for the long term, but they are more tempting

to trade more often than index funds.

Filangeri also noted that ETFs aren't appropriate for investors who dollar-cost

average their purchases or redemptions. Buying small amounts of ETF shares

each month is expensive because of the brokerage fees.

A less well-known risk is that, like closed-end mutual funds, ETFs can trade

at premiums or discounts that vary from the net asset value of the underlying

index of stocks. An investor could thus lose money buying at a premium and

selling at a discount, even if the underlying index is doing well. Some

experts say the premium/discount risk is more likely to occur with ETFs

that track market sectors or international stock indexes.

Clearly, Filangeri said, exchange-traded funds offer some features that

help broaden an investor's options. But don't automatically jump into them

until you determine whether they're appropriate for your needs.

—Zall, Bureaucratus columnist and a retired federal employee, is a freelance

writer based in Silver Spring, Md. He specializes in taxes, investing, business

and government workplace issues. He is a certified internal auditor and

a registered investment adviser. He can be reached at miltzall@starpower.net.