Known legally as open-end investment companies, they issue new shares when investors want to buy them at NAV per share (plus a sales charge for front-end load funds) and they must redeem shares at NAV (less a sales charge for back-end load funds) when holders want to sell. No-load funds do not have sales charges, though a brokerage firm may charge a nominal transaction fee.

These characteristics have long distinguished mutual funds from another kind of investment company, a closed-end fund, which offers a fixed number of shares upon creation. Shareholders are then free to buy and sell those shares on the stock market exchanges, just as they would buy and sell a single stock. A problem often emerges, however, when the price of the fund shares starts to diverge from the value of the underlying stocks held by the fund. This creates what is known as a discount or a premium to NAV. Investors trying to replicate the performance of the underlying stocks may be faced with "tracking error", which means that they may not achieve the investment return they would have received if they'd invested in the stocks directly.

Open-end mutual funds lack the ability to be traded intra-day, for a known market price (mutual funds are priced once per day after the markets close), and closed-end mutual funds develop tracking error. In order to address these limitations, a hybrid type of fund was created: It is known as an Exchange-Traded Fund (or ETF, for short). ETF's provide all of the benefits of both the open-end and closed-end mutual funds, without the limitations of each. In addition, because of the way they are structured, they tend to be very tax-efficient and have very low cost structures, both of which benefit investors.

Exchange-traded funds (ETF's) were introduced in 1993 by a subsidiary of the American Stock Exchange. They are designed to give investors a vehicle that resembles mutual funds but also provides the opportunity to have buy or sell orders promptly executed at known prices on a securities exchange (through a broker) whenever markets are open.

The first ETF was introduced in 1993. It was named the SPDR Trust (for Standard & Poor's Depositary Receipt), and the shares were referred to as "Spiders." Its investment policies were similar to those of the mutual funds that had been passively managed to match the performance of an established index, beginning with the Vanguard 500 Index Fund in 1976, and followed by other domestic and foreign stock and bond index funds over the next few decades. Three more ETF's followed the SPDR model, tracking the S&P MidCap 400, the Dow Jones Industrial Average, and the NASDAQ 100. Each of the original ETF's was formed as a Unit Investment Trust, which still had some limitations (the composition of a UIT is fixed at creation). However, in 1996 the first two ETF's structured as open-end investment companies were introduced. This was really when the true "hybrid" was born.

Since then, ETF's have experienced phenomenal growth. By the end of 2005, ETF total assets had reached $296 billion, and it is possible to create a well-diversified investment portfolio incorporating a broad array of asset classes using only ETF's. Because of their enormous popularity, companies have responded by rolling out ETF's tracking most of the major indices, such as the Standard & Poors, Russell and MSCI indices. Why have ETF's been so successful in attracting investors over the past ten years?

• Professional management and access to broad diversification with relatively small initial investment requirements - when all is said and done, ETF's are still mutual funds, but without any of the mutual fund's perceived limitations. The majority of ETF's track established indices, though many actively managed ETF's are under development.
• Attractive cost structure - ETF's tend to have much lower expense ratios than comparable open-end mutual funds. This is typically due to the fact that issuers of ETF's do not have to keep track of their shareholders the way mutual fund companies do. However, because ETF's are bought and sold like stocks, investors may pay commissions to buy and sell them. ETF's may not be appropriate for investors with very small amounts to invest or for those engaged in dollar cost averaging (for this reason, they may not be appropriate for investment of bi-weekly 401(k) deferrals).
• Tax-efficiency - Because of their legal structure, ETF's can be tax-managed far more effectively than traditional mutual funds. Given that unanticipated capital gains distributions is cited as one of the key drawbacks of traditional mutual funds, this is quite an advantage for ETF's. Many ETF's have not distributed any long- or short-term capital gains in five years or more and if for those that have, the distributions have been very small.
• Trading flexibility - as noted above, mutual funds are purchased and redeemed at their daily net asset value once per day after the close of the markets (the markets close, the closing value of all of the fund's holdings are summed, and the total value is divided by the number of outstanding fund shares). There is no way to know in advance the purchase or redemption price of the fund. ETF's, on the other hand, are traded constantly throughout the day, and the current market price will give an investor a good idea as to the likely price at which the fund will be bought or sold. In addition, ETF's can be sold short (unlike open-end mutual funds), and the normal up-tick rule when shorting stocks does not apply to ETF's.

June 2006 - This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hutchinson & Ziegler Financial Advisors, a local member of FPA.