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Advantages of ETF's, Stock Baskets Weighed

The mutual fund industry has historically showed its resilience to competitive products and predictions of its demise have always proven false. So it is not likely that several products that have gained recent attention from investors and the financial media will spell the end of the fund industry, said industry executives speaking at the Morningstar Investment Conference last week.

However, products like individual stock baskets and exchange-traded funds have caught on with investors and financial advisers and moved into the mainstream because they offer advantages over traditional mutual funds, said Scott Cooley, a senior fund analyst with Morningstar, a moderator on a panel that discussed new, low-cost investment products. The panel included Gus Sauter, director of the Vanguard Group's Quantitative Equity Group, Steven Wallman, founder of FOLIOfn and Brad Zigler, head of educational material for Barclay's exchange-traded funds.

Since Barclay's launched its iShares ETF fund lineup a little over a year ago, fund investors have gradually become more familiar with ETF's and the advantages they offer over traditional funds, Zigler said. ETF's have succeeded because they provide investors with a lower cost, tax-sensitive option to traditional and regular index funds, he said. In fact, since launching, several of the iShare funds have accumulated no capital gains taxes and many are the lowest cost index funds available, Zigler said.

Attracting Long-Term Investors

Vanguard decided it would attach its new ETF share class, VIPERs, on several of its index funds as a way to draw short-term traders out of its conventional share classes, Sauter said. "Index investors always wrestle with short-term investors," he said. "The flexibility of (VIPER) shares will attract short-term investors."

Vanguard will offer VIPER shares on its Extended Market fund in September and will attach the class on subsequent funds at two-month intervals, he said.

However, the cost advantages of ETF's over mutual funds might be a bit overstated, according to Sauter. Some ETFs are more expensive then a standard index fund, he said. Moreover, because ETF's can only be bought and sold through a brokerage, many investors overlook the added costs of conducting transactions, he said.

But most brokerages offer investors a limited number of trades each month, so transaction costs are often not a factor, Zigler said.

ETF Product Development

There has been much speculation about what new variations of exchange-traded funds will be developed, including how an actively managed ETF will operate and when the first bond ETF will be developed. The wait for the first bond ETF may soon be over, according to Zigler.

"We hope to see them launched this year," he said. Bond ETF's will offer the bond market many of the same advantages ETF's offered stocks, namely lower expenses and pricing transparency, he said.

But developing an actively managed ETF may prove to be a bigger challenge and will likely take many years before one is offered, he said. But the hallmark of an ETF is the transparency of its portfolio, he said. "There has to be a balance between these two and it will take time to figure this out."

Whether there is even a market for such a product may be a better question, Sauter said. "Is there a demand for this? I'm not sure added flexibility of an ETF adds value to active management," he said. "I guess I'm a little bearish on the concept."

While ETF's offer investors trading throughout the day and tax advantages, FOLIOfn's stock baskets offer customization, according to Wallman. Investors and advisers can assemble a basket of as many stocks as they want and can add or delete individual stocks in order to meet their specific needs, he said. And because the stocks in the basket are fractionalized shares, investors can achieve as much diversification as they want for a minimal cost, he said.

However, the Investment Company Institute has lobbied heavily against the product, claiming it should be regulated under the same rules as a mutual fund.