Exchange-Traded Indexed Securities


Exchange-traded funds (ETFs) are increasing in popularity, as they are often responsible for approximately 50% of the daily trade volume on the American Stock Exchange (AMEX). ETFs are passive funds that track their related index and have the flexibility of trading like a security. They are managed by professionals and provide the investor with diversification, cost and tax efficiency, liquidity, marginability, are useful for hedging, have the ability to go long and short, and some even provide quarterly dividends.

ETFs are unit investment trusts (UITs) that have two markets. The primary market is where institutions swap "creation units" in block-multiples of 50,000 shares for in-kind securities and cash in the form of dividends. The secondary market is where individual investors can trade as little as a single share during trading hours on the exchange. This is different from open-end mutual funds that are traded after hours once the net asset value (NAV) is calculated.

The most widely traded and well-known ETF is the SPDR (pronounced spider, Standard and Poor's Depository Receipt). Other ETFs include Diamonds (Dow Jones Industrial Average), Qubes (Nasdaq-100 Index Tracking Stock) named after the ticker, QQQ, and Webs (World Equity Benchmark Shares). Webs mirror indices in foreign equity markets. There are currently 30 ETFs available on the AMEX and they include 17 Webs, 11 SPDRs (includes sectors), and one Qube and one Diamond.

Tax Advantages

Like open-end index funds, ETFs do not engage in active management and experience very low portfolio turnover. Also, ETFs provide additional tax benefits that mutual funds cannot offer. Mutual funds sell securities to cover redemptions that produce capital gains. ETFs transfer out, not sell, securities "in-kind" in the primary market. The institution can determine which, and how much of a security they are going to swap as long as it is of equal value to the amount being redeemed. The benefit of swapping securities at the lowest cost-basis is that it avoids capital gains. However, individual investors trading in the secondary market could be subject to capital gains since they do not have the opportunity to swap securities in kind.


Most open-end index funds can be purchased directly from their distributors without a transaction fee. Those bought through the discount brokers like Charles Schwab or E*Trade usually include a transaction charge of $15-$30 or more. Exchange-traded funds, on the other hand, are subject to regular brokerage commissions on all purchases and sales. An additional cost to investors in ETFs is the "spread" between the bid and ask price. This can amount to over 1% of the purchase or sale price.

Expense ratios (ER) are very similar among ETFs and open-end index funds. However, there is often an additional cost of ownership to holding ETFs. SPDRs, for example, pay dividends quarterly directly to investors. An open-end index fund like the Vanguard 500 Index reinvests dividends into new shares as they are paid. The delay of dividend reinvestment with ETFs is often referred to as "dividend drag."

Exchange-Traded Fund
Symbol ER
Nasdaq-100 Index Tracking Stock QQQ 0.18%
SPDRs SPY 0.18%
MidCap SPDRs MDY 0.25%
Basic Industries Select Sector SPDRs Fund XLB 0.65%
Consumer Services Select Sector SPDRs Fund XLV 0.65%
Consumer Staples Select Sector SPDRs Fund XLP 0.65%
Cyclical/Transportation Select Sector SPDRs Fund XLY 0.65%
Energy Select Sector SPDRs Fund XLE 0.65%
Financial Select Sector SPDRs Fund XLF 0.65%
Industrial Select Sector SPDRs Fund XLI 0.65%
Technology Select Sector SPDRs Fund XLK 0.65%
Utilities Select Sector SPDRs Fund XLU 0.65%
Diamonds DIA 2.53%*
WEBS - Australia EWA 1.05%
WEBS - Austria EWO 1.41%
WEBS - Belgium EWK 1.04%
WEBS - Canada EWC 1.14%
WEBS - France EWQ 1.18%
WEBS - Germany EWG 1.08%
WEBS - Hong Kong EWH 1.09%
WEBS - Italy EWI 1.02%
WEBS - Japan EWJ 1.04%
WEBS - Malaysia (Free) EWM 1.09%
WEBS - Mexico (Free) EWW 1.34%
WEBS - Netherlands EWN 1.12%
WEBS - Singapore (Free) EWS 1.08%
WEBS - Spain EWP 1.11%
WEBS - Sweden EWD 1.17%
WEBS - Switzerland EWL 1.15%
WEBS - United Kingdom EWU 1.03%


* 0.18% after expense reimbursement by fund manager.

New and Improved ETF

Barclays Global Investors (BGI) currently manages all 17 of the WEBs available on the AMEX and has filed with the SEC with plans to offer 51 new ETFs including 45 domestic and 6 international sector and wide-market indices. BGI is planning a competitive pricing strategy and the internal expense ratio estimates range between 8 and 12 basis points. Their goal is to design tax efficient and less expensive funds to grab market share. A key difference between the Barclays securities and the currently available ETFs is that they will be registered with the SEC as open-end funds. BGI is still keeping the benefits of exchange-traded securities while overcoming the problem of dividend drag.

Exchanged-trade index funds offer investors even greater flexibility than open-end index funds and may offer cost and tax advantages. Investors should be aware, however, that the unique advantages of ETFs, such as greater trading flexibility and the ability to sell short, might turn out to be very costly features in the long run. Investors are still wise to avoid the temptation of market timing and use ETFs as part of a diversified, long-term investment strategy.

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