by Archie M. Richards, Jr., CFP^®
August 27, 2001

Want to own diversified portfolios of stocks, but trade each of them as you would regular stocks? Exchange-traded funds (ETFs) may be just the thing.

Exchange-traded funds are based on indexes, the first of which was created by Standard & Poor's. As a basis, S&P chose several hundred large U.S. stocks (not 500, at first). To the collective values of these stocks on January 2, 1943, S&P assigned an index value of 10. On each successive day, the index was moved up or down by the same percentage as the change in the collective market value of the selected stocks. The S&P 500 Index now stands at almost 120 times the original value. Since 1943, you see, the U.S. economy has grown a tad.

The first mutual fund designed to track an index, the Vanguard 500 Index Fund, started in 1975. Vanguard acquires in the proper proportions all 500 of the stocks included in the S&P 500 Index. As the Index goes, so goes the fund. Other mutual funds belittled Vanguard for not trying to beat the Index. But the fund got the last laugh. It has outperformed the others and is now the largest mutual fund in the world.

Index funds, however, have a problem. They can be bought and sold only at market after trading closes. A decision to buy at the opening won't be executed until many hours later, when the price may be very different.

The first exchange-traded fund (ETF) came along in 1993. Based on the S&P 500 Index, its shares are referred to as Spiders. You can trade them throughout the day, using market orders, limit orders, or any kind of order you like.

Spider shares are created and redeemed by the Spider Trust when prompted by "Authorized Participants." We're talking heavy money, here; minimum blocks of 50,000 Spider shares, worth about $6,000,000.

The Authorized Participants (APs) tend to be large pension plans. They profit by keeping the price of Spiders close to the net asset value per share of the Spider Trust, that is, close to the Index value. Let's say the Spider price becomes 25 cents higher than the NAV per share of the Trust. This means there aren't enough Spider shares. An AP immediately buys all five hundred of the S&P stocks, submits them to the trustee, and receives Spider shares. The AP sells those shares, bringing the Spider price closer to the net asset value per share of the Trust.

Assume that the Authorized Participant sells some of those Spider shares to you. When you later sell them, you would do so to another investor. Once created, ETF shares are ordinarily passed from one investor to another in the secondary market.

Okay, now let's assume that the price of Spiders becomes 25 cents lower than the net asset value per share of the Trust. This means there are too many Spider shares. An Authorized Participant therefore buys Spider shares, submits them to the trustee, and receives S&P 500 stocks, which the AP sells, again bringing the Spider price closer to the value of the Index.

The process of keeping the value of an ETF close to the value of the underlying index is called arbitrage. No matter whether you own an exchange-traded fund long term or short term, its price is as close as possible to the value of the index.

There are now over 130 exchange-traded funds. An ETF for the Nasdaq 100 (called Qubes; symbol QQQ), an ETF for the Dow Stocks (called Diamonds; symbol DIA), and the aforesaid Spiders (symbol SPY) have the largest volumes and the smallest variances.

Exchange-traded funds are neat little packages. Each one represents an entire portfolio of stocks, but it can nevertheless be traded without limitation. They are remarkable inventions.

After examining four decades of the growth and poverty of eighty nations, World Bank staff members found that open trade and the rule of law helped the poor and the nonpoor proportionately. But reducing inflation and cutting government spending helped the poor more than the rich.

What? Cutting government spending helps the poor more than the rich? U.S. legislators don't seem to have gotten the message.