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Charles Mizrahi
Charles Mizrahi

ETFs - The New Game in Town

June 19, 2007

Over the past several years ETFs have become some of the most actively traded issues on the New York Stock Exchange. What are they, why are they so heavily traded, and who is benefiting from this explosion in popularity? ETFs (exchange-traded funds) are nothing more than index funds. There are close to 700 ETFs, including the ones that are in the registration process with the SEC. Only 12 ETFs represent broad market segments, such as the S&P 500 and the Morgan Stanley EAFE (Europe, Australia, and Far East) index of non-US stocks.

When index funds started to gain in popularity back in the early 1980s, they were geared toward investors who could now match the returns of the S&P 500 index without the complexity and transaction costs of buying all 500 stocks. Buying an index fund also eliminated sales fees, operating expenses, and portfolio turnover. In effect, one could achieve the S&P 500's total return with minimal drag of expenses.

Over the years, index fund investing gained so much in popularity that by 1988 the total assets of index funds (mainly the S&P 500 index) had grown to $5.6 billion, which represented about 1 percent of total assets of equity mutual funds. Close to 20 years later, $1 trillion out of the $6.2 trillion equity total assets, or 17 percent of total equity assets, represents index funds. Of that $1 trillion, $420 billion is invested in ETF assets. An investor who had no clue which stock to buy could now invest in an index fund, sit back, and match the performance of the stock (a feat that over 90 percent of money managers can't achieve). Not content with investing in just S&P 500 index funds, Wall Street created a slew of ETFs for virtually every sector and subsector in stock markets the world over (e. g. , CurrencyShare Mexican Peso Trust and HealthShares Emerging Cancer). However, something happened along the way, and investors in index funds and ETFs forgot why they invested in them in the first place. Investors in ETFs have turned them into day-trading vehicles. The ETF sector averages annualized turnover of over 2, 500 percent, which comes out to an average hold time of only two weeks. Over 20 percent of the trading volume on the NYSE is made up of ETFs. Fund managers are making a fortune on these passive investments. The average management fee expense for an ETF is 0.24 percent. But since they are passive investments, how do the managers justify such a fee?

In addition, the ease of trading ETFs has tempted many financial planners into repositioning their clients' assets into the hottest market sectors. Weren't index funds created to allow investors to take a passive position and gain exposure to an index over the long term, avoid high management fees, and have low transaction costs? It seems that's not the way events have played out. The old Wall Street saying has never been more appropriate: "The more financial intermediaries take, the less their clients make."

Source: John C. Bogle, "Value Strategies, "Wall Street Journal, February 9, 2007, p. A11.

About the author:

Charles Mizrahi
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 5.0/5 (2 votes)


Vooch - 10 years ago    Report SPAM
> Fund managers are making a fortune on these passive investments. The average

> management fee expense for an ETF is 0. 24 percent. But since they are passive

> investments, how do the managers justify such a fee?

Is that 0.24% or 24%? The space between the 0. and 24 implies a typo.

If it's 0.24%, that's a hell of a lot better than the 2%/20% or 2%/50% crowd.

- Vooch

Armeetofo - 10 years ago    Report SPAM
john is a winner,

ETF's, indexs are those foods in the menu that the chefs like johns' offers to their clients, nothing esle.

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