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ETFs Continue to Proliferate, Specialize: Providing Individual Investors with Institutional Tools

Increasingly, exchange-traded funds have individuals acting like institutional investors - or, at least, are offering them the tools to do so.

The latest example is a spate of currency funds unveiled by Rockville, Md.-based Rydex last week, which will track six of the most liquid currencies from around the world, those of Australia, Canada, Great Britain, Mexico, Sweden and Switzerland.

These new products join Rydex's CurrencyShares lineup, which debuted with the Rydex Euro ETF on the New York Stock Exchange last December. To date, that fund has attracted $650 million, increased 5.4% and trades about 300,000 shares per day.

"We are giving [retail investors] something they didn't have in the past," said Steve Sachs, director of trading at Rydex. "Access."

Foreign currency can be a good hedge against volatility and a substitute for cash, if used properly as part of one's portfolio, said John M. Mulvey, a professor of financial engineering at Princeton University, who has worked as a consultant to Rydex for nearly a year and a half and who helped develop these funds.

Not only do these currencies offer a new asset class, but it is one with low correlation to other segments of the market and relatively immune to "contagions," or those rare, but large, events that sweep the market, simultaneously weakening stocks, bonds and commodities and turning once-robust portfolios sickly, Mulvey said, speaking during a news briefing at the NYSE last week.

Institutional investors can access such leveraging techniques by going to the spot market, to dealers or to foreign exchanges. But for individuals, these tactics, for the most part, are simply out of reach.

These ETFs change that. The Rydex Currency Funds act as trusts, each with only one asset. In the case of the Euro fund, that asset would be Euros, for example, and in the case of the Swedish fund, it would be kronas. Investors purchase shares with U.S. dollars and can buy as little as a single share. The funds trade on the NYSE, beginning this week, which adds transparency and price assurances not available on the spot market.

The assets for each will be held in an account at JPMorgan in London and accrue interest at institutional rates, which will be paid out as monthly dividends in U.S. dollars, Sachs said. Because they are denominated in U.S. dollars, and traded on the NYSE, the funds are both accessible and bear no special foreign tax liability.

Expenses are capped at 40 basis points, plus bank fees, which, for the Euro CurrencyShares product, has been 27 basis points.

"Its back to, do you have access? Do you like the transparency?" Sachs said.

During a press conference, Sachs dodged multiple questions about potential currency shares to follow, such as one based on the Japanese yen, but did concede that the model could be applied to other denominations.

"We don't see any slowdown of products coming to market," Sachs said. "The trend is capturing innovations and opening new asset classes to investors."

The proliferation of ETFs in the past two years has been remarkable. At the end of 2004, there were 151 funds on the market, representing $226.2 billion in assets, according to a report from the Securities Industry Association. One year later, there were 201 funds with $296 billion.

The surge continues. Between January and April this year, 16 new products came to market, bringing an additional $10 billion in assets, according to SIA data. Earlier this month, PowerShares Capital Management, based in Wheaton, Ill., announced plans to launch 31 new funds, rounding out its existing lineup of 37 ETFs. These funds combine indexing with a quantitative overlay that sets weightings for stocks by tracking 25 various financial, momentum and valuation characteristics.

And Thursday, State Street Global Advisors of Boston introduced six industry-specific exchange-traded funds, bringing its total SPDR roster to 65. The new funds will track metals and mining, pharmaceuticals, oil and gas equipment, oil and gas exploration and production, consumer retail sales, and regional banking.

The SEC has another 23 applications pending, according to spokesman John Heine, and some applications represent several separate funds.

"Exchange-traded funds will become the mutual funds of the 21st century as assets in exchange-traded funds surpass $1 trillion by the end of the decade," heralds a report released in late April by Tiburon Strategic Advisors, a research company in San Francisco.

Other estimates are even higher. In a recent report, New York-based research and consulting firm Celent pegged the ETF market at $1.95 trillion by 2010.

"In terms of aggregate sales, ETFs have done great," said Owen Concannon, an analyst with Boston-based Financial Research Corp. "Certainly, they are finding their way to retail investors as more and more advisors adopt a fee-based business." Rydex is one example of a fund provider that targets advisers, rather than the direct market.