"All of the research undertaken by active managers keeps prices closer to values, enabling indexed investors to catch a free ride without paying the costs."
- William F. Sharpe, Nobel Prize Laureate

Exchange Traded Funds

ETFs are securities that combine essential elements of individual stocks and index mutual funds. Like stocks, ETFs are traded on the major U.S. stock exchanges and can be bought and sold at any time during market hours. Like index mutual funds, ETFs are baskets of securities that seek to replicate the performance of specific market indexes, such as the S&P 500 and the Lehman Treasury Indexes. This unique combination provides investors with the following key benefits:

Low Costs. ETFs have a cost advantage, on average, in excess of 1% relative to actively managed mutual funds.

A 1% cost advantage has a significant impact on a portfolio's performance over time. Assuming an equivalent 8% gross return compounded over 20 years, a portfolio with a 1% cost advantage will have an ending value more than 20% higher than a portfolio burdened with higher expenses. Costs are among the few controllable variables in a portfolio's returns. Exchange-traded funds provide an opportunity to enhance net returns by reducing investment expenses.

Performance. ETFs address the problem of benchmark underperformance by actively managed mutual funds. Numerous studies have shown that the majority of actively managed mutual funds underperform their benchmark indexes. The high rate of underperformance relative to indexes principally results from the expenses associated with active management. The minority of actively managed funds that do outperform their benchmarks is not a static group. So while it is possible to identify outperforming funds in hindsight, the difficulty lies in identifying such funds in advance.

Diversification. ETFs allow investors to buy an entire market segment with one security, thereby avoiding the risks of owning individual stocks. ETFs own most or all of the securities that constitute an index, and exact portfolio holdings are disclosed on a daily basis, providing full transparency.
Tax Efficiency. Tax efficiency is a critical issue that is often overlooked by investors. Delaying the taxation of appreciating assets may significantly enhance after-tax returns over time. Mutual funds have been criticized for tax-inefficiency. According to Lipper, during the ten-year period ended December 31, 2002, taxable investors in mutual funds gave up 1.5% to 1.8% in return per year - as much as 25% of their returns - because of taxes.

The tax inefficiency of mutual funds is the result of two factors:

1. Portfolio turnover at the fund level caused by the trading activity of the portfolio manager and the activity of other shareholders in the fund.

2. The "pooled structure" of a mutual fund, which can cause a new investor in the pool to inherit an unrealized "embedded" capital gain that he or she did not benefit from but which could result in a tax liability.

In contrast, ETFs have a unique product structure which allows them to substantially mitigate or possibly avoid capital gains distributions. Because ETFs trade on an exchange just like stocks, ETF shareholders have more control over their tax situation because they are not impacted by the purchases and redemptions of other shareholders.

"All of the research undertaken by active managers keeps prices closer to values, enabling indexed investors to catch a free ride without paying the costs." - William F. Sharpe, Nobel Prize Laureate Exchange Traded Funds

"All of the research undertaken by active managers keeps prices closer to values, enabling indexed investors to catch a free ride without paying the costs."
- William F. Sharpe, Nobel Prize Laureate

Exchange Traded Funds