ETFs Evolve -- For Better or Worse?

With their low fees, all-day trading and tax efficiency, exchange-traded funds (ETFs) have captivated investors. There were no ETFs before 1993, and only 80 in 2000. By the end of 2006 there were 359. Today, there are nearly 700, including 280 launched in 2007 and 30 through mid-March this year. They hold about $600 billion.

While most experts think ETFs were a good innovation -- built like index-style mutual funds but traded like stocks -- some worry that the increasingly specialized ETFs introduced in recent years stray from the faith, encouraging too much risk-taking.

That concern is heightened for some by recent Securities and Exchange Commission proposals to let new funds come to market with less oversight, and to invite proposals for introducing actively managed ETFs. Like actively managed mutual funds , these would employ teams of stock pickers and analysts trying to beat the market's gains rather than simply match them, as today's ETFs do. "I can't imagine anything more absurd than an ETF that is [actively] managed," says John C. Bogle, retired founder of The Vanguard Group, the leader in index-style mutual funds and ETFs.

Bogle is equally critical of the now-prevalent class of narrowly defined ETFs, which typically focus on stocks of specific industries or countries. "They are great for brokers," he adds, noting that narrow ETFs appeal to speculators who buy and sell frequently and pay lots of sales commissions. "The question is, are they any good for investors?" Most small investors, Bogle argues, do best by choosing a handful of broad-market index investments and holding them for the long term.

Others experts, however, argue that new types of ETFs can be useful to many investors. "It just gives people more choice," says Wharton finance professor Franklin Allen, pointing out that narrow focus and active management have long been available in mutual funds. "This is just like mutual funds. It's just a slightly different organizational form.... If you think health care is going to do well if [Hillary] Clinton gets [elected president], for example, you may want to take a position on that, and these [ETFs] provide an easy, low-cost way to do it."

Low Operating Costs

The first ETF was the SPDR (Standard & Poor's Depository Receipt) -- commonly known as Spyder SPY -- which started trading on the American Stock Exchange in 1993. Still one of the largest ETFs, with $66 billion in assets, it owns the 500 big-company stocks in the Standard & Poor's 500 index. The value of a Spyder share precisely tracks the index's ups and downs.

The Spyder follows in the tradition of the first index-style mutual fund offered to ordinary investors -- The Vanguard 500 Index VFINX introduced by Bogle in the mid-1970s. It, too, tracks the S&P 500, and it is one of the largest funds, with $110 billion in assets.

Because index products simply try to match market returns rather than beat them, they do not require armies of analysts hunting the latest hot stocks. Their operating costs therefore are extremely low. Since they trade like stocks, ETFs require virtually no interaction between the fund company and the investor, producing savings in administrative costs that also minimize fees paid by investors.