ETFs Become More Complex (AP) (10-01-2008)

NEW YORK (AP) -- Investors get more and more attracted to exchange-traded funds, index funds that trade like stocks and the sector is creating more complex instruments.

The latest instrument providers are registering to offer are the first actively managed ETFs. These may beat their benchmarks, but have higher expenses, just like actively managed mutual funds.

Among problems that these may have is investor confidence in managers, which takes a while to build as will be holdings updates as frequent disclosure may make it easy for other investors to copy the fund’s moves. One such fund, PowerShares, says it will update holdings daily, on its Web site. Mutual funds must do so quarterly.

New last year, exchange-traded notes, are also controversial as they promise an index's return, less management fees. Because they're debt securities, investors take on the risk the issuer will default. Unlike ETFs, ETNs do not hold stocks, bonds or commodity contracts directly; the providers do. ETNs have tax advantages over ETFs, which themselves are more tax-friendly than mutual funds. With many ETNs, investors don't incur income or gain until they sell.

Now, the government is looking into whether this is an unfair advantage. Congress may act in 2008, says Thomas Humphreys, a partner at the Morrison & Foerster law firm.

"This is just sort of a symptom of a larger problem ...We probably need a complete overhaul of how we tax these instruments," he said.

Comparing exchange-traded funds with mutual funds:

Total assets, as of October 2007

ETFs: $588.18 billion, traditional mutual funds: $12.356 trillion

What they hold: ETFs: Seemingly anything covered by an index, from stocks to currencies, mutual funds: Global stocks and bonds

When they are priced: ETFs: In real time, throughout the trading day, Mutual funds: After trading closes

Average expense ratios: ETFs: 0.30% for U.S. stock; 0.50% fro international stock

Mutual funds: 0.72 percent for U.S. stock; 0.99 percent for international stock (passively managed)

Transaction costs: ETFs: Yes, must pay commission to broker, mutual funds: Often no

Ability to short shares: ETFs: Yes, mutual funds: No

Trading restrictions: ETFs: None, they trade like stocks, mutual funds: Many limit short-term trades

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