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How You Could Make Your Million Owning Mutual Funds 401

investors but also asset managers, we started covering ETFs in February
2006.
ETFs are basically mutual funds that trade like a stock, but offer trans-
parency, tax efficiency, and lower expenses.
While mutual funds set their prices or net asset value (NAV) once a day,
the prices of ETFs jump up and down throughout the day, just like a stock
price. Anything you can do with a stock, you can do with an ETF, such as
selling short and trading options.
ETFs are more tax-friendly than mutual funds because of what happens
under the hood. When market makers need to create or redeem shares, they
round up the underlying stocks and trade them with the provider for new
ETF shares. They do the opposite to redeem ETF shares for the underlying
stocks. No money changes hands because the shares are traded in-kind.
Unlike mutual funds, ETFs are not affected by shareholder redemptions.
If too many investors pull money out of mutual funds, fund managers may
be forced to sell the stocks they hold to raise cash, thereby incurring a tax-
able event. ETFs keep trading to a minimum, so there are few taxable gains.
ETFs charge management fees of anywhere from 0.10% to 0.95%. That’s
considerably smaller than those of mutual funds, which charge 1.02% on
average. 1
However, with a good mutual fund, you’re getting a top-notch manager
who makes investment decisions for you. An ETF requires that you pull the
buy and sell triggers.
Don’t kid yourself that the diversification in an ETF will somehow pro-
tect you. Take the SPDR Financial Sector (XLF). In the banking meltdown
in 2008, this ETF plunged 57%.
The SPDR (SPY), which tracks the S&P 500, was the first U.S.-listed
ETF. It started trading on the Amex in 1993. The Nasdaq 100, known today
as PowerShares QQQQ Trust (QQQQ), and the Diamonds Trust (DIA),
which tracks the Dow Jones Industrial Average, were both launched in the
late 1990s.
Today, there are ETFs tracking not only benchmark indexes, but also
bonds, commodities, currencies, derivatives, carbon credits, investment
strategies such as low-P/E stocks, and more. In 2007 and 2008, ETF
launches were what IPOs were to the Internet bubble. Providers floated
ETFs based on esoteric indexes that diced sectors into ridiculous slices such
as Wal-Mart suppliers, spin-offs, companies with patents, those that don’t
do any business with Sudan, and those engaged in “sinful” activities like
gambling, alcohol, and tobacco.

1
Investment Company Fact Book (Investment Company Institute, 2008).