Why ETF deserves a prize

By EDWIN A. FINN JR.

Our special issue on ETFs is a primer for newcomers and state-of-the-industry report for pros.

EXCHANGE-TRADED FUNDS probably rank as the most successful financial product of the past two decades. They have cut costs, minimized risks and allowed investors to know at any point in time exactly what they own. Many of our readers, be they financial advisors or individuals, use ETFs already. But many do not. That's why we decided to ask the staff of Barron's to prepare this special issue, which serves as a primer for newcomers but also a state-of-the-industry report for experienced hands.

ETFs are not for everyone. Many investors will always want to beat the market by picking their own stocks and bonds. Others want to accomplish the same thing by picking expert portfolio managers to do the job. Still, whether you choose to use ETFs or not, it's important to know how they work and how other investors are using them.

When ETFs were introduced in the early 1990s, they seemed a gimmick. Much was made of the fact that, unlike mutual funds, ETFs allowed investors to buy and sell at current market prices during the day. That was important to some professionals. But most individuals don't have much need to jump in and out of the market hourly.

As it turned out, the attributes that contributed the most to the explosive growth of ETFs among individuals were not ease of trading but tax efficiency and low cost. While mutual-fund managers must sell stocks when clients redeem shares, ETFs do not, thus limiting owners' tax bills. As for the cost savings, they come about largely because ETFs don't have fund managers.

A substantial part of the investing public has voted with its feet. ETFs now hold about $700 billion in assets, which amounts to nearly 15% of the $4.5 trillion held in traditional equity mutual funds. As Mike Santoli points out in his story, "Growing to the Sky," ETF assets are expected to grow by more than 20% a year for the next five years, while mutual funds grow at a much slower pace. A good part of the growth will come from high-net-worth individuals, who, as Lawrence Strauss notes in "Why the Rich Like These Bare-Bones Products," are getting more comfortable with the funds.

Leslie Norton reports in "Do Emerging-Markets Funds Have More Upside?" that ETFs have proven one of the best ways to play emerging markets because they spread risk among many stocks and, again, rein in costs. The same goes for investing in small and medium-sized companies, as explained by Dimitra DeFotis in "Small Stocks, Big Gains." The latest growth area is fixed-income, where an ETF can buy bonds to mimic a certain bond index. See Tom Sullivan's story, "Putting Bonds in Your Portfolio Mix." If you're interested in owning gold through an ETF, see Dow Jones Newswires' reporter Allen Sykora's story, "Insuring Against Economic Calamity."

Sector ETFs can be used to carry out straightforward underweighting and overweighting strategies as well as more complex maneuvers. Depending on how they're used, these sector funds can play either defensive or aggressive roles in an investor's portfolio. See "What You Need to Know About Sector ETFs" by Barrons.com's Bob O'Brien.

Please feel free to send us any questions about ETFs or about ETF investing strategies. We can be reached at editors@barrons.com or at Barron's, 1211 Avenue of the Americas, New York, N.Y. 10036.