A market crash should provide lessons for every investor, although far too many have short memories. In March 2000, the stock bubble popped. By the fall of 2002, the S&P had declined 46% percent from its peak and the NASDAQ lost a staggering 72% percent of its gain, known as “giving back.”
Mutual funds were not immune to the fall. There is only so much a fund manager can do to avoid having their funds follow the market. They suffered equally – to the surprise of most of their shareholders – who expected their managers to outperform the indexes. They were paying good money for the expertise of these managers, and they didn’t seem to be getting it. Stock mutual funds declined en masse and some of the high-profile funds gave back much more than the S&P 500. Even balanced funds, those invested in both stocks and bonds, suffered, to the dismay of investors who selected them as a more conservative investment.
Billions of dollars flowed into aggressive growth and technology funds in the late 1990s as a result of mutual fund companies spending millions on advertising and pushing their high-flying funds. Remember those days when you couldn’t open a newspaper or magazine without seeing a mutual fund company touting its funds? It was those aggressive growth and technology-heavy funds that touted glowing track records, as if these exorbitant returns would continue forever.
Listening to chants from financial analysts that “this time is different,” most of the shareholders of the hottest funds came on board in 1998-1999, just in time for the bear market’s emergence from hibernation in 2000. The high-profile funds lost altitude quickly. Unfortunately, the fund companies weren’t handing out parachutes to shareholders.
As the stock market decline worsened, mutual fund call center phones rang off the hook. Shareholders were holding the line, and they wanted some answers about their deteriorating savings. The mandate came down from mutual fund management: Tell the shareholders that ups and downs are natural for the stock market, and that it’s more important not to panic and to adopt a “long-term perspective.” That had to be a reassuring thing for someone just a few years from retirement to hear.
Back then, being a phone rep for a fund company must have been like working in the complaint department at White Star Line Shipping in 1912, the year in which the Titanic sunk. The fact is, investors got caught up in the hype of the stock market boom of the 1990s, and fund companies did little to protect investors from what was coming. In fact, many saw an opportunity to capitalize, and they did just that.
In the wake of the market decline, the scandals, and the realization that few funds outperformed their benchmarks, the number of mutual funds began to consolidate. Today there are a little more than 8,000 mutual funds, down from a high of 11,000 at the market top in 2000. Each year, 300 to 500 mutual funds are lost because poor- performing funds are being killed off or merged with other funds that have better track records.
Enter the exchange traded fund (ETF).
Much like mutual funds during their rapid growth period, ETFs are sprouting up like June corn in an Iowa field. After hitting the market in 1992, ETFs now hold nearly $600 billion in assets in nearly 600 funds. Considering that only 32 funds were trading in 1999, representing only $36 billion, their ascent has been dramatic. By comparison, the mutual fund industry, which began in 1924, took 60 years to reach the same asset level that ETFs enjoy today. The exchange traded fund market is expected to grow 33 percent annually until 2010, reaching almost $2 trillion.
Some days several new ETFs come to market. And if there isn’t an existing index – say, something for a particular country or currency – ETF providers will go ahead and create an index and build an ETF around it if there’s enough interest. Although the first – and, by far, the most popular – ETFs were the traditional ones that track stock indexes, an ever-growing variety of ETFs cover specialized sectors and markets (stocks, currencies, commodities).
Chances are, you could find an ETF that seems as though it was tailor made for you. And much like the mutual funds did when they were proliferating, new ETFs are appearing all the time from a combination of factors – chiefly, consumer demand and whatever is the latest, hottest sector.
What makes them so attractive to investors?
- They’re served up in a basket. Like mutual funds, ETFs pool various securities – stocks, bonds, commodities, currencies – into one package. Most often these packets are reflected by an index that represents a large group of investments. The Standard & Poor’s 500 index represents the 500 largest stocks by market value, for example. This basket is then treated like an individual security and listed on an exchange. Constantly creating and redeeming shares “in-kind,” ETFs exchange shares for pools of underlying securities.
- They make trading easy. As separate, listed securities, ETFs trade just like stocks. You can buy and sell them through brokers, and they are traded throughout the day. Their prices constantly reflect changes in market prices. They are different from open-ended mutual funds, in which investors buy shares in a pool of securities. Mutual funds are not listed on exchanges. When you purchase shares in an open-ended mutual fund, new shares are created. With ETFs, you buy them the same way you would a stock, using techniques such as shorting (selling in anticipation of a price drop), limit-buys, and stop-loss orders. You can also write options – both calls and puts – against ETFs. You can’t do that with mutual funds.
- You know what you’re buying. ETF managers publish their holdings every day and note any changes. Most portfolios that represent an index rarely change at all. You know what you own at all times. What you see is what you get. That’s not possible with an open-end, actively traded mutual fund, which only has to publish quarterly statements and won’t fully disclose its trading expenses. As such, ETFs are not subject to the kind of trading abuses that have ravaged mutual funds in the last decade. Exchange traded funds are continuously repriced throughout the trading day, so late trading isn’t possible. In comparison, the net asset value (NAV) of traditional mutual funds is always a trading day’s closing price.
- Their cost is very low. Because there’s little in the way of trading costs – holdings in index ETFs are rarely sold[md]management fees are low. Although you’ll pay a brokerage commission to buy or sell them (we recommend working with a deep-discount broker), expenses are minimal in ETFs because they are efficient. Considering that the average actively managed stock mutual fund charges you 1.50 percent per year in management expenses, the savings are significant, according to Morningstar, Inc., the Chicago-based financial information company. The average U.S. stock ETF charges .41 percent annually.
- They’re tax friendly. If an actively managed, open-end mutual fund has a good year, you’ll often pay for it in taxable gains outside of a tax-deferred account. Not so in most ETFs, which are largely insulated from the need to sell holdings for shareholder redemptions. Most index ETFs have static portfolios that are passively managed, so they generate gains only if a security needs to be sold because the index keepers have changed the index. So most ETFs don’t generate capital gains from buying and selling components; you pay tax only on profits from selling your ETF shares, meaning that you also control the timing of taxable outcomes.
- They help you diversify and reduce risk. Because ETFs are broad baskets of securities, they can represent entire markets. Want to buy a fund representing all listed U.S. or foreign stocks? How about sampling most large overseas stocks? Or U.S. bonds? ETFs can do that and more. By giving you exposure to more securities, they lower your portfolio risk. You need never buy another single stock or actively managed mutual fund again. Why gamble far too much money on what you think will be the next Google when you can buy an entire fund full of potential winners from all over the world?
Investors around the world are eager to learn all they can about ETFs and figure out how they can take matters into their own hands with these innovative and exciting funds. Stick with us, and we’ll show you how.