Tracking Down a Better Deal

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It's an evergreen complaint that Europeans pay more than their North American counterparts for just about everything, from furniture to plane tickets to cookies. Now add this to your list: index-tracking funds and trusts. In the U.S., such "passively" managed mutual funds have proved enormously popular, because they've consistently beaten most money managers. But most of the American funds have a built-in advantage: they often charge less than .25% a year. Not so on the other side of the Atlantic. The biggest index-tracking unit trust in the U.K., the Virgin Direct U.K. Index Tracking Trust — which replicates the FTSE All Shares index — costs 1% a year. High street banks charge about the same for their trackers and tack on a 4% or 5% setup fee as well. On the Continent, indexing has yet to really take off at all.

All that may be about to change, thanks to the arrival of an intriguing new product called the exchange traded fund, or ETF. These funds, which have already grown to more than $30 billion in assets in the U.S. despite sinister names like spdrs ("spiders") and webs, work just like any normal mutual fund or unit trust except that they can be traded instantaneously on stock exchanges. Unlike closed-end funds or investment trusts, ETF prices will always be fixed to the underlying value of the stocks they hold. Large institutional investors would step in to take advantage of, or arbitrage, even the smallest imbalance, and thereby correct it. An ETF can be purchased through most stockbrokers, including online discounters like Schwab and E*Trade.

The killer advantage to these funds will be costs. The first London Exchange-listed index tracker, called the iFTSE 100 because it mimics the FTSE 100 index of the largest British firms, went on sale in April with a total expense ratio of just .35%. Only a handful of traditional indexed trusts — among them, the trackers sold by Fidelity, Legal & General, and Liontrust — have anything near that low a price today. Chances are, this will have to change. After all, the IFTSEs are managed by Barclays Global Investors, the very same San Francisco-based money manager that works behind the scenes for the more expensive trusts sold at Marks & Spencer stores and, ahem, the local Barclays branch. (The bank and the money manager have the same corporate parent.)

Consumers are unlikely to keep paying three times as much for exactly the same product for long — and trust managers need not go to the poor house to get competitive. Jonathan Harbottle, marketing director at Liontrust, says his company's supercheap index tracker still "turns a tidy profit." The selection of exchange-traded funds is growing fast. NASDAQ Europe is teaming up with the combined London and Frankfurt iX exchange, and one of the first securities it plans to list on the new pan-European market is the high-tech NASDAQ 100 tracker, known in the U.S. as Qubes for the ticker qqq. And just before the big merger announcement, the Deutsche Börse opened trading on two funds called ldrs ("leaders"), which will track the Dow Jones stoxx 50 and Dow Jones Euro stoxx 50 indexes. Those indexes follow blue chips across Europe and in the E.U., respectively. ldrs will cost no more than .5% a year.

So can anything go wrong with an ETF? Gus Sauter, who runs index funds in the U.S. for Vanguard — which itself has just announced that it will be opening ETFs — warns that the market mechanisms that keep these funds' market prices in line with their true value could break down in a market panic. He points to the market crash of 1987, when S&P 500 index futures — which, like exchange traded funds, rely on arbitrage to work — briefly traded at more than a 10% discount to the index. Managers at Barclays dismiss this as mere speculation; since the launch of spdrs seven years ago, ETFs have an excellent record for accurate tracking.

The biggest danger with these funds is really yourself. Exchange traded trackers offer unprecedented flexibility. Like a stock, you can leverage your position in them by borrowing money from your broker to buy more shares, or even wager against them by setting up a so-called short sale. Steve Malinowski, a managing director at Merrill Lynch, which helped to develop the ldrs, hopes that ETFs will be attractive to investors looking for "performance vehicles" — that is, a way to make quick moves in and out of one stock market or another — and not just to the long-term buy-and-hold crowd.

But for most of us, buy-and-hold works — for much the same reason indexing does. It is extremely difficult to outguess the market profitably, especially after you factor in the brokerage costs you incur every time you buy and sell. Research by Terrance Odean, a professor of finance at the University of California at Davis, has found that retail stock investors in the U.S. tend to do worse the more they trade. And no matter how low the fees are on an ETF, if you buy high and sell low, you will still lose your shirt.

Pat Regnier is a staff writer at Money magazine in New York