Like closed-end funds, ETFs offer shares that can be traded on exchanges at competitive bid/ask spreads throughout the day, and these shares can be margined. Management fees and expenses are low -typically from 0.08% to 0.50% on domestic funds and 0.40% to 1.00% on international funds. Standard brokerage commission rates apply on purchases and sales. Unlike mutual funds, ETF shares can be shorted.

The main difference between ETFs and closed-end funds is a feature that eliminates the large discounts (to NAV) at which many closed-end funds trade. That feature is the ability to purchase large blocks of shares, called "creation units," and redeem shares (usually in 50,000 minimum blocks) in exchange for the underlying securities. Since arbitrageurs can buy small blocks of ETFs and package them into creation units, the free market keeps discounts to NAV relatively low.

ETFs organized as open-end investment companies can reinvest any income received. A few ETFs are organized as unit trusts, and these may not reinvest income.

According to the Investment Company Institute, the U.S. market offered 108 ETFs as of October of 2002 divided into the following categories: 36 U.S. equity index funds, 33 U.S. equity sector funds, 35 global or international equity funds, and 4 fixed income funds. Total assets in ETFs were $100.7 billion as of 10/02, of which $92.0 billion was in domestic funds. For historic reference, five years ago there were just two domestic ETFs and the industry's total assets were less than $5.0 billion. The leading packagers of ETFs include Merrill Lynch (HOLDRs), Barclays Global Investors (iShares), State Street Global Advisors (streetTracks), Standard & Poor's (SPDRs), Vanguard (VIPERs), and Nasdaq (Cubes).

#1: Fee-Based Implementation

Some financial advisors took a first look at ETFs and turned up their noses. Clients can buy ETFs for one brokerage fee, hold them years, and never pay the advisor another dime. That's not motivating for transaction-based advisors. But the compensation chemistry changes in a fee-based brokerage account or discretionary separate account. In these accounts, ETFs can be used as either buy-and-hold or dynamically-managed implementation tools, while the advisor earns a continuing asset-based fee. Unlike mutual fund trails, these accounts can offer fee discounts to win competitive cases and breakpoints to attract more client assets. ETFs make great sense for advisors who have already made a commitment to fee-based client relationships.

#2: Cost-Efficiency

At first glance, ETFs appear to offer modest cost advantages over actively managed mutual funds, and minimal cost benefit over traditional index funds. But look closer at who pays costs, and they start to magnify. In a fee-based relationship, clients are becoming more cost-conscious while focusing on their total ("all-in") cost. Trends suggest that in the future a significant part of the market may be willing to pay no more than about 2.0% annually for all fees and expenses combined. At that threshold, the typical mutual fund wrap account, with two levels of fees, can become unrewarding for advisors. If ETFs can reduce the cost of underlying funds by 20-50 basis points, which is typical, the advisor potentially can pocket that much more revenue without meeting price resistance. Over time, it can accumulate to significant compensation advantages. ETFs have a structural cost advantage over mutual funds because they don't bear the burden of holding accounts and issuing statements for thousands of investors.

Reason #3: Top-Level Strategies and Index Tracking

According to recent research, a growing segment of the High Net Worth market wants a "top-level" investment strategy implemented on an advisory basis. For this segment, the top-level strategy is perceived to have greater value than the specific product selection or active management of underlying investments. Top-level strategies can include strategic or tactical asset allocation, market timing, sector rotation, and tax optimization. Often, these strategies depend on underlying investments that accurately track a designated benchmark. According to a study conducted by Bloomberg, ETFs are slightly more accurate in index tracking than corresponding index mutual funds, mainly because mutual funds are required to wait until the end of the day to reinvest dividends. ETFs organized as open-end investment companies can reinvest immediately.

Reason #4: Tax Efficiency and Optimization

ETFs have a significant advantage over all mutual funds in their ability to minimize the impact of taxable distributions, because they are not subject to shareholder redemptions and portfolio liquidations. According to the Bloomberg study, capital gains distributions in ETFs were just 0.31% of NAV for a recent period studied, compared to 5.87% in index mutual funds. This resulted in ETFs delivering more than 1.0% of extra after-tax return. In the future, ETFs will be used extensively in "tax optimization" services which seek to track performance of designated benchmarks while maximizing after-tax return. For example, a sector-based optimization strategy might periodically sell the worst performing sector ETF to "harvest a tax loss." This loss then can be used to offset the client's other investment gains, or deducted against ordinary income up to $3,000 per year. (If Congress increases the annual deduction limit above $3,000, demand for tax optimization will grow.) Some wealthy investors will pay 0.50% more annually for a top-level strategy with a tax-optimized overlay. Some RIAs and financial planners are using software to offer this service, while capturing higher ongoing fees.

Reason #5: Tax-Lot Accounting

Along with tax optimization, the High Net Worth market places extra value on strategies in which the advisor's CPA can specify individual securities lots to sell for tax advantages. Delivering this service requires ability to capture and track tax-lot accounting data on client statements. This data is being consolidated in brokerage accounts more efficiently than it can be captured and evaluated from an assortment of mutual fund groups. Even before ETFs became hot, many advisors recognized the difficulty of delivering to CPAs a hodge-podge of tax data from various fund groups, in a variety of formats. A common solution was to transfer mutual fund shares into a brokerage account with tax-lot tracking capability. Unlike mutual funds, ETFs were designed to take advantage of the tax-reporting and consolidating efficiencies of brokerage account custody.

Reason #6: Alternative Asset Classes

The recent popularity of hedge funds has demonstrated demand for new asset classes, including market-neutral strategies and short equities. Since 1997, mutual funds have had the ability to own short positions, but most fund groups have been slow to open access to alternative investment. One small group, Rydex, currently dominates the market for short and leveraged index funds. Rydex funds are expensive to own and have demonstrated a spotty record of tracking designated benchmarks accurately.

Unlike mutual funds, ETFs can be sold short on much the same basis as individual stocks. A companion product, Single Stock Futures (SSFs), made its debut in the U.S. on November 8 through two new exchanges, Nasdaq Liffe Markets and OneChicago. SSFs allow highly leveraged long and short positions in individual stocks and leading indexes. It is possible that ETFs and SSFs together will become so successful in implementing alternative strategies that they will preempt expansion in this area by mutual funds. Since ETFs and SSFS can be bought in cost-effective and transparent brokerage accounts, they also may steal momentum from hedge funds, with their costly and opaque structures.

Reason #7: Real Time Monitoring

The advisory market is about to be transformed by sophisticated real time portfolio monitoring services -including style analysis, risk monitoring, and performance attribution. Delivered online, these services can "flag" portfolios that deviate from pre-determined criteria and alert advisors to make changes "on the fly." Several of the more sophisticated services have chosen to evaluate individual securities, not actively managed funds, because it's too difficult to track the moment when specific securities are added by fund managers. ETFs can be evaluated on the same basis as individual securities, so it's easier to integrate them into real time monitoring services.

Reason #8: Momentum, Publicity and Demand

ETFs appear to have unlimited potential in terms of the variety of funds they can offer or volume of assets they can capture. Soon, you'll see ETFs that mix 10-15 different stocks. You may also see ETFs that steal the thunder of "Rydex-style funds" by mixing long and short positions in one exchange-traded vehicle.

You know a product is huge when it turns other products into dinosaurs. ETFs won't turn mutual funds into dinosaurs, especially in the retirement plan market. But they've already turned traditional closed-end funds and unit trusts into dinosaurs. Before long, ETFs and SSFs together may make some hedge fund structures obsolete too.

The financial press loves to tell investors how to save money, so favorable publicity about ETF cost benefits may grow. If a millionaire client asks whether your investment discipline will work as well with ETFs as with mutual funds, what are you going to say?

In Summary

It may be a coincidence that ETFs have hit the market just as many advisors and clients are turning to fee-based relationships. But it's a great opportunity for fee-based advisors to expand the range of assets classes they offer, while increasing their portfolio services and revenues.

To get in the ETF game, some advisors face barriers. For example, they may be reluctant to add new asset classes that clients want, because it means obtaining new software and creating new allocation models.

My advice is to confront those barriers now, not later. At a minimum, add a real estate asset class to your models, and use ETFs to do it -e.g., streetTracks Wilshire REIT or iShares Cohen and Steers Realty Majors, both Amex-traded. If you are using a mutual fund wrap product that doesn't allow ETFs, start looking for alternatives that do. Don't let ETFs turn you into a dinosaur!