10 Things You Need to Know: Exchange-Traded Indices Pose Threat to Mutual Funds

This story is part of a weeklong series that looks at the top 10 trends to help you invest in the coming year. Click on the tile at left to see other stories.

Exchange-traded funds arrived during the 1990s, but they may own the year 2000.

Barclays Global Investors, the world's largest indexing firm, will be betting big money on a new line of exchange-traded index funds. The firm has filed paperwork to launch more than 30 of these products, and the first cluster is expected to hit the market around the end of the first quarter.

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Investors can also expect to see more products from existing players State Street Bank & Trust and Merrill Lynch (MER Quote).

These plans set the stage for a mammoth battle between traditional mutual funds and their exchange-traded cousins.

Fund Killers? Exchange-traded securities attracted billions of dollars in investment in 1999
Exchange-traded security	Launch date	Assets on Jan. 1 ($mil.)	Current assets*
Spider (SPY Quote)	Jan. 29, 1993	$12,200	$17,000
Nasdaq 100 tracking stock (QQQ Quote)	March 10	0	5,300
Diamonds (DIA Quote)	Jan. 23, 1998	457	1,200
MidCap Spider (MDY Quote)	May 4, 1995	1,500	2,000
Merrill Lynch Internet HOLDRs (HHH Quote)	Sept. 23	0	1,300
Select Technology Sector Spider (XLK Quote)	Dec. 22, 1998	157	936
Merrill Lynch Biotech HOLDRs (BBH Quote)	Nov. 22	0	650
*Data as of 12/17/99 and reflect price appreciation. Source: Amex.

"I think the implications of exchange-traded funds are a negative for the fund industry," says Henry McVey, a brokerage and asset management analyst at Morgan Stanley Dean Witter.

"This is another attractive alternative to the traditional mutual fund and comes at a time where the retail mutual fund industry is already experiencing slowing growth," he says.

Exchange-traded portfolios are like typical funds in that investors can buy the equivalent of a portfolio of stocks through a single investment.

However, investors can buy and sell shares of exchange-traded securities throughout each trading day -- just like stocks -- paying typical brokerage commissions.

Because they track indices, these securities are cheaper than actively managed stock funds. Proponents of these products also praise their tax efficiency as they tend not to make taxable distributions to shareholders.

"They are a more convenient, better-priced product that investors can use in lieu of mutual funds. You still get the diversification benefits but with greater flexibility in buying and selling them," McVey says.

Investors obviously have gotten the message.

The Nasdaq 100 tracking stock (QQQ Quote) came out in March of last year, and the underlying portfolio hit $6 billion in assets in December. Part of this product's attractiveness certainly stems from the performance of the Nasdaq 100 itself. It finished 1999 up 102%.

In late September, Merrill Lynch came to market with its Internet HOLDRs (HHH Quote) security, shares of which represent a fixed basket of 20 Internet stocks. In three months, the portfolio was holding $1.3 billion.

Such allure didn't always exist.

Standard & Poor's Depositary Receipts (SPY Quote), or Spiders, were the first exchange-traded shares to hit the market in 1993.

They were not an instant hit. Once program traders got involved in the market later that year, the volume did pick up. But they didn't really take off until the rise of the S&P 500 in the mid-1990s focused attention on that index and on indexing in general. The Spider portfolio, of which State Street is the trustee, now commands $17 billion in assets.

Despite the massive amount of attention that exchange-traded portfolios received in 1999, the market for these products is still incredibly small compared to that for mutual funds.

Right now, there's only around $35 billion in exchange-traded portfolios worldwide, according to State Street's estimates. By comparison, S&P 500 index funds alone controlled $228 billion at the end of November, according to Lipper.

Exchange-traded products are "a very small piece of the mutual fund industry," says Gus Fleites, head of exchange-traded products at State Street Global Advisors, the money management division of State Street Bank & Trust.

To change that, two things need to happen. "One: Have more product come to the marketplace," Fleites says. "Two: Have the retail market buy into the structure, and that hasn't happened yet. You're up against the big mutual fund companies that spend millions and millions of dollars in advertising."

The first part of that equation is a sure thing.

Barclays will hit the market this year with its family of products. State Street plans to launch six more exchange-traded index portfolios late in the first quarter, including ones covering growth, value, small-cap, Internet and technology, Fleites says.

Merrill Lynch is expected to launch more HOLDRs covering additional sectors and segments of the market. (The firm already operates Internet and Biotech (BBH Quote) HOLDRs.)

Even Vanguard, the king of traditional mutual fund indexing, is examining the possibility of launching a Spider-like series of products. However, a Vanguard spokesman says no decision has been made on that front.

Attracting retail investors to these securities is the bigger challenge. However, lower costs could drive individual investors into this market.

Index funds are, at their heart, a commodity product. Whoever carries the lowest expenses on their products could garner a big chunk of the market.

When Barclays introduces its own S&P 500 product in 2000, the firm is expected to undercut the 0.18% annual expense ratio of the Spider and the (VFINX Quote)Vanguard 500 Index fund. The expense ratio on the Barclays 500 portfolio could be as low as 0.08% to 0.14%.

State Street might lower the fee on the Spider to compete with Barclays, although the firm hasn't yet made a final decision, Fleites says.

Expenses on the Merrill Lynch HOLDRs are virtually nonexistent. The fixed portfolios carry a $2 quarterly custody charge per 100 shares, but whatever portion of that fee isn't covered by dividends is waived.

Plus, Merrill has the power of its massive brokerage force to sell these products. (Investors, however, can buy them from any broker, full-service or discount.)

Lastly, the trend of investors buying stocks instead of funds could benefit exchange-traded funds, which are bought and sold like equities.

There's also talk of actively managed exchange-traded funds. But some professionals don't expect to see that for at least a year, if not longer.

That's a story for 2001.

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