Scandal-Free Mutual Funds

For a while late last year and early this year, it seemed that one mutual fund family after another was being implicated in some sort of scandal. In fact, the widening scandal included some of the nation’s most recognizable fund companies, including Janus Capital Management and Alliance Capital Management. (See “How Do the Mutual Fund Scandals Affect You?” on blackenterprise.com.) Investors began asking themselves, “Is there any place we can turn to avoid being ripped off?”

“We prefer exchange-traded funds, or ETFs, relative to mutual funds,” says Sean Clark, chief investment officer of Clark Capital Management Group, an investment firm in Philadelphia. “[ETFs] offer the same benefits as mutual funds, such as diversification and professional portfolio management, yet there are many reasons to invest in ETFs instead of mutual funds.”

As the name suggests, ETFs trade on stock exchanges, usually the American Stock Exchange. There are hundreds of listed ETFs, but they generally fall into one of two categories: closed-end funds and index ETFs. Closed-end ETFs tend to be actively managed by an investment adviser, meaning that the sponsoring

company picks out certain stocks or bonds for the fund. They are also not generally redeemable. For example, the newly formed Nuveen Tax-Advantaged Total Return Strategy Fund invests in floating-rate loans as well as in stocks that pay low-taxed dividends.

Other closed-end ETFs might hold virtually any type of investment vehicle, from California-issued municipal bonds to stocks issued by companies in Thailand. Their performance can be excellent. The Website www.etfconnect.com reports that one of last year’s leaders, Thai Fund, returned more than 150% through November 2003.

Index ETFs track a particular index, from the Dow Jones Industrial Average to Morgan Stanley’s index of issues trading on the Tokyo Stock Issue. Unlike closed-end ETFs, shares for an index ETF can de redeemed daily. “These ETFs go by names such as iShares, SPDRs [spiders], and HOLDRS [holders],” says Clark. “They tend to be less expensive and more tax efficient than index mutual funds. ETFs trade all day long, which precludes the illegal trading practices that caused the mutual fund scandals.” Again, some index ETFs enjoyed a spectacular year in 2003 with returns as high as 104%, such as iShares’ Goldman Sachs Networking Index Fund, which holds technology stocks.

How ETFs Differ From Mutual Funds
With a mutual fund, investors buy and sell shares from and to the fund itself. Investors trade ETFs among themselves. “Some mutual funds impose redemption fees if you buy and sell the fund within, say, 90 days,” says Clark. “That’s not the case with ETFs.” However, you will incur transaction costs with ETFs (similar to making a stock trade). So if you elect to buy them, you may do better working with a low-cost discount broker.

Another benefit: “With an ETF, you’re not buying someone else’s basis. This helps them to be tax-efficient,” says Clark. To give an example, suppose you buy a small-cap index fund. The best performing stocks will grow to become mid-caps, so they won’t be eligible for that small-cap fund any more. A mutual fund will have to sell those stocks, take profits, and pass on the taxable gains to shareholders. You might purchase shares in a mutual fund April 1 and owe tax on a trade that the fund makes April 2, even though you didn’t participate in the gain that’s being taxed.

By comparison, ETFs are allowed to use techniques that minimize such phantom taxation. “Your basis is the price you pay for the shares,” explains Clark. “You’ll have a taxable gain or loss depending on the price you get when you sell the ETF shares. You control your tax obligations.”

The Case for Closed-End Funds
William Adams IV, executive vice president of Nuveen Investments in Chicago, asserts that closed-end ETFs offer additional benefits to investors: “Managers don’t have to be concerned with redemptions so they needn’t hold a great deal of cash.” Over a long time period, cash holdings, such as money market funds, will likely have lower returns than the stocks and bonds where closed-end funds put their money. “Closed-end funds also avoid the timing issues that redemptions can bring,” says Adams. That is, money often flows in

to mutual funds at market highs, leading to high-priced buys, and flows out near market bottoms when the fund could use extra cash to buy bargains. That’s not an issue with redemption-free closed-end ETFs.

What’s more, closed-end ETFs generally sell at a premium or discount to the securities they hold. A fund might hold $100 million worth of stocks (at current market prices) and have 10 million shares outstanding for a per-share value of $10. Funds trading on an exchange, however, might be priced at $10.50 per share, $9.50, or even $9. “Buying closed-end funds at a discount can be a major advantage to investors,” says Adams.

“Currently, many closed-end funds sell at a discount,” says Thomas Herzfeld of Herzfeld Research in Miami. “Investors have pulled money out of some closed-end funds managed by the same companies that have been named in the mutual fund scandals. As demand for these funds has dropped, discounts have grown larger. Buying closed-end funds at a discount may be the best choice for investors.”

Top 10 Closed-End ETFs by 3-YearNAV Return (Through Feb. 29, 2004)

Fund Name	Exchange: Ticker	Category	NAV 1-Year Return	NAV 3-Year Return	NAV 5-Year Return
Templeton Russia	NYSE: TRF	Europe Stock	67.05	40.85	35.03
MS Eastern Europe	NYSE: RNE	Europe Stock	82.34	36.59	25.98
Thai Fund	NYSE: TTF	Pacific/Asia Stock*	108.31	35.56	19.89
China Fund	NYSE: CHN	Pacific/Asia Stock*	78.95	33.81	29.42
First Financial	NYSE: FF	Specialty — Financial	55.71	33.23	27.67
Indonesia Fund	NYSE: IF	Pacific/Asia Stock*	114.14	32.08	11.57
Thai Capital	NYSE: TF	Pacific/Asia Stock*	101.06	31.29	8.39
Korea Fund	NYSE: KF	Pacific/Asia Stock*	58.82	26.44	25.74
Renaissance G&I III	NAS: RENN	Mi d-Cap Blend	140.99	25.77	22.79
Templeton Dragon	NYSE: TDF	Pacific/Asia Stock*	83.61	24.99	23.40
Source: Morningstar Inc. Morningstar makes every effort to ensure the completeness and accuracy of this data but cannot guarantee it. *Fund excludes Japan.

Top 10 Index ETFs by 3-Year Return (Through Feb. 29, 2004)

Fundname	Exchange: Ticker	Category	1-Year Return	3-Year Return	5-Year Return
iShares S.Korea Index	AMEX: EWY	Pacific/Asia Stock*	62.49	25.29	NA
iShares Austria Index	AMEX: EWO	Europe Stock	72.89	23.19	11.06
iShares C&S Realty	AMEX: ICF	Specialty-Real Estate	46.11	19.31	NA
iShares DJ RE Index	AMEX: IYR	Specialty-Real Estate	46.93	18.52	NA
streetTRACKS SmCap V	AMEX: DSV	Small-cap Value	61.41	17.88	NA
iShares Australia	AMEX: EWA	Foreign Large Blend	55.98	17.26	10.37
iShares R2000 Value	AMEX: IWN	Small-cap Value	63.48	14.50	NA
iShares Mexico Index	AMEX: EWW	Latin America Stock	70.65	13.64	14.20
iShares Malaysia	AMEX: EWM	Pacific/Asia Stock*	39.17	11.90	21.22
iShares S&P 400 BA V	AMEX: IJJ	Mid-cap Value	55.68	11.82	NA
Source: Morningstar Inc. Morningstar makes every effort to ensure the completeness and accuracy of this data but cannot guarantee it. *Fund excludes Japan.