Passive institutional investors use ETFs because of their flexibility, active traders invest in ETFs for their convenience and hedge funds utilize ETFs for their simplicity. ETFs may be easily purchased in small amounts like stocks and don’t require special documentation, special accounts, rollover costs or margin. Additionally, ETFs are exempt from the short sale uptick rule, which prevents short sellers from shorting a regular stock unless the last trade provided a price increase.

It already sounds like a compelling argument in favor of ETFs.

Costs in tracking an index.

* Rebalancing. Rebalancing in index mutual funds because of net redemptions generate explicit costs from commissions and implicit costs from bid-ask spreads on the underlying fund trades. ETFs are made with an innate creation/redemption design that avoids these transaction costs.

* “Cash drag.” Index funds also incur costs when holding cash to deal with potential daily net redemptions. ETFs don’t incur this cost due to their creation/redemption process.

* Dividends. Index funds have an advantage over ETFs in their dividend policy. Index funds will invest dividends immediately while ETFs would accumulate the cash and distribute it to shareholders at the end of the quarter.

Non-tracking costs.

* Management fees. ETF costs are lower because the funds are not responsible for the funds’ accounting – the brokerage will take in these costs for the ETF holder.

* Shareholder transaction costs. ETF shareholder transaction costs come from commissions and bid-ask spreads, which is determined by the ETF’s liquidity. Shareholder transaction costs are usually zero for index mutual funds.

Americans held $3.9 trillion in employer-based defined-contribution retirement plans, of which $2.7 trillion was held in 401(k) plans as of Sept. 30, according to the Profit Sharing/401k Council of America. Mutual funds had $2 trillion of those assets, but ETFs are starting to chip away, as they have with everyday trading among institutional and individual investors.

BlackRock estimates that as much as $2 billion of its iShares funds are now held in 401(k) plans, accounting for half that market. “Within the 401(k) space in the next five years, it is conceivable that flows to ETFs could reach several billion dollars,” says Darek Wojnar, head of product research and strategy at BlackRock’s iShares, its ETF unit.
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The main selling points are low and transparent fees. According to BlackRock, the average expense ratio of an iShares ETF is 0.41% versus the average mutual fund’s 1.50%, a difference that can result in tens of thousands of dollars over 30 to 40 years.
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In 2007, WisdomTree Investments(WSDT) created a business unit designed to deliver ETFs to the 401(k) marketplace. In all, the company sells 52 funds.

Whenever rates move back up, you won’t have to just sit still and accept it. Exchange-traded funds (ETFs) give you many ways to protect your principal and profit from rising rates. Today I’ll tell you about three of them …

Rising Rate Protection ETF #1:
iShares 1-3 Year Treasury ETF (SHY)

A cardinal rule of debt is that overstretched, low-income borrowers pay higher interest rates. And right now no one is more burdened with debt than the U.S. government.
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When rates do go up, the first domino to fall will be long-term bonds: Treasury debt maturing in ten years or more. This means you can expect a stampede into the short end of the maturity scale. Then the shortest-term Treasury paper will go up in value simply because so many people will want to own it.

SHY is an ETF tailor-made for this scenario. It holds Treasury debt that matures in the 1-3 year range. This is a “sweet spot” for investors: Long enough to give you some time, but short enough to avoid long-term forecasting errors.

Could SHY get hurt if short-term rates go up? Absolutely. However, I still think this ETF will outperform long-term bonds over the next few years, all things considered. So take a look at SHY for money that you need to keep safe.

Rising Rate Protection ETF #2:
ProShares UltraShort 7-10 Year Treasury (PST)

When interest rates go up, bond prices go down. That’s because newly-issued bonds will pay higher rates than older ones, which makes the old ones worth less.

The longer the maturity, the more the price is affected by rising rates. And the change can be significant for bonds in the 7-10 year range. That’s where an inverse ETF like PST can help. PST could rise as much as 10 percent for each 1 percent jump in the 10-year Treasury rate.

PST does this by shorting Treasury bonds. And while that can work for short-term trades, it’s not a very good long-term strategy …

Moreover, PST employs 2x leverage, so you are effectively paying interest twice.

The best opportunity for making money with PST is to own it for no more than a few weeks when 10-year interest rates are going up. If you hang on after rates level off, you could actually lose ground and your profits will eventually disappear because of the interest payments.

Rising Rate Protection ETF #3:
Direxion Daily 30-Year Treasury Bear 3x Shares (TMV)

If you believe long-term rates are headed up, and soon, TMV could be your ticket to major profits. It’s an inverse ETF that tracks 30-year bond prices with 3x leverage.

Suppose, for instance, interest rates spike higher and the 30-year bond price index falls 5 percent in a day … you can expect TMV to rise 15 percent on that same day. Yowza!

This leverage could also be a ticket to major losses. For example, if your timing is off, even by a few days, you could get your head handed to you. That’s why leveraged ETFs are intended only for the most aggressive investors.

Vanguard made these changes to make the funds more tax friendly and to make them more closely track their respective indices. Before the switch, Vanguard’s sector ETFs and mutual funds tracked traditional MSCI sector indices, which weigh individual companies from their respective sectors based purely on stock market values.

Although this is the most efficient way to ensure that the indices provide the most realistic view of the actual makeup of the market, using them to create ETFs raises red flags with the IRS.

To prevent a fund from becoming too heavily weighted in a small number of holdings, the IRS has implemented a number of diversification rules that ETF and mutual fund providers must comply with in order to qualify for favorable tax treatment. Failure to meet these requirements results in double taxation.
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The importance of keeping tracking error to the minimum is highlighted by Vanguard’s success with its emerging-market ETF.

Over the past few months, investors have been fleeing from the iShares MSCI Emerging Markets Index Fund (EEM) and pouring into the Vanguard Emerging Markets ETF (VWO). These two instruments track the same index: the MSCI Emerging Market Index. At first, one would assume that comparing these funds would be akin to comparing apples to apples. However, if one delves deeper into the inner workings of the two funds, it becomes apparent why investors choose one over the other.

Although each of these funds seeks to track the performance of the same index, each does so differently. The EEM uses a sampling process, leading to the construction of a fund consisting of 439 of the more than 700 constituents in the MSCI Emerging Market Index.

VWO, on the other hand, tracks more than 800 positions, making it even more diverse than the index. By tracking a sampled version of the index, EEM’s performance at times will not always mimic the index.

Year to date through March 3, VWO’s more comprehensive approach to tracking its index has paid off. Not only has the fund seen massive investor inflows, but it has managed to outperform EEM, which is down -2.1% compared with EEM’s 3.3% drop. The MSCI Emerging Market Index is down 2.3% over the same period.

Seeing the success of VWO, it’s no wonder that Vanguard has taken an important step to fix the tracking error issues facing its sector focused instruments while meeting the requirements of the IRS. The funds now track brand new underlying indices.

Rather than tracking the traditional versions of the MSCI indices, Vanguard’s sector funds now track MSCI 25/50 indices, which meet the IRS requirements.