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Working

Paper

Series

EXCHANGE

TRADED

FUNDS:

A

NEW

INVESTMENT

OPTION FOR TAXABLE

INVESTORS

James

M.

Poterba

John

B.

Shoven

Working

Paper

02-07

January

2002

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E52-251

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42

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Massachusetts

Institute

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Department

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Working

Paper

Series

EXCHANGE

TRADED

FUNDS:

A NEW

INVESTMENT

OPTION

FOR

TAXABLE

INVESTORS

James

M.

Poterba

John

B.

Shoven

Working

Paper

02-07

January

2002

Room

E52-251

50

Memorial

Drive

Cambridge,

MA

02142

This

paper can be

downloaded

without

charge

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the

Social Science

Research Network Paper

Collection at

CHUSETTSinstitute

OFTECHNOLOGY

Exchange Traded

Funds:

A

New

Investment

Option

for

Taxable

Investors

James

M.

Poterba

MIT

Department of

Economics

and

NBER

John

B.

Shoven

Stanford University

Department

of

Economics

and

NBER

January

2002

ABSTRACT

Exchange

traded funds

(ETFs)

area

new

varietyof

mutual fund

thatfirst

became

availablein 1993.

ETFs

have

grown

rapidly

and

now

hold nearly

$80

billion in assets.

ETFs

are

sometimes

described as

more

"taxefficient" thantraditional equity

mutual

funds, sinceinrecent years,

some

large

ETFs

have

made

smallerdistributions ofrealized

and

taxablecapitalgainsthan

most mutual

funds. This paper provides

an

introductiontothe operation

of exchange

traded funds. It also

compares

thepre-tax

and

post-tax returns

on

the largest

ETF,

the

SPDR

trustthat

invests inthe

S&P500,

withthe returns

on

thelargestequityindexfund, the

Vanguard

Index

500.

The

results suggestthat

between 1994 and

2000, the before-

and

after-taxreturns

on

the

SPDR

trust

and

this

mutual fund

were

very similar.

Both

the after-tax

and

the pre-tax returns

on

the

fund

were

slightly greaterthan those

on

the

ETF.

These

findings suggestthat

ETFs

offer

taxable investors a

method

of

holding

broad

baskets

of

stocksthatdeliver returns

comparable

to

those

of

low-costindexfunds.

We

are grateful to

Yingcong

Lan

forexcellentresearchassistance,

and

toDanielBergstresser,

Rob

Engle,

Burton

Malkiel,

and

especially Joel

Dickson and John

Rea

for

many

helpful

discussions.

The Hoover

Institution,the National ScienceFoundation,

and

theFinance

Program

of

the StanfordInstitute for

Economic

Policy

Research

provided us withresearch support.

Exchange

traded funds

(ETFs)

are a rapidly

growing

class

of

financialproducts.

ETFs

aretypically organized as unittrusts.

They

were

introduced in 1993,

and by

the

end

of 2001, they

held

$79

billion in assets

—

2.4percent ofthetotal assets inequity

mutual

funds.

The

share

of

equitymutual fund assetsheld through

ETFs

doubled

in

2000

and

rose

by

nearly fiftypercentin

2001

.

With

several years

of

continued

growth

atthispace, theassetsheldthrough

ETFs

will

rivalthe

amount

heldinequityindex funds.

Exchange

tradedfundsare

of

interesttopublicfinanceresearchers

concerned

with

taxation

and

portfoliobehaviorfor

two

reasons. First, theyrepresent

new

financialinnovations

thatare

sometimes

describedas prototypesforthe futureevolutionofthe

mutual fund

industry.

Itis thereforeimportanttounderstandtheirtax treatment

and

theirafter-taxreturns. Second,

ETFs

areoften

promoted

asbeing

more

"taxefficient" thantraditional equity

mutual

funds.

By

reducingthetax

burden

on

investmentsincorporate stocks,relative to investmentsinsuch stocks

held through equity

mutual

funds,

ETFs

may

therefore

move

closertothe consumption-tax

treatment

of

corporate capital income.

Inthisbriefpaper,

we

compare

thepre-tax

and

after-taxreturn

on

the largest

exchange

tradedfund, the

SPDR

trustthatholds thesecurities in the

S&P500,

withthereturns

on

the

largestequity indexfund, the

Vanguard

Index

500

fund. This

fund

tracks the

same

indexas the

SPDR

trust.

We

extendthe

ETF

return calculations

of

Elton, Gruber,

Comer, and

Li (2000)

by

focusing

on

alonger

sample

period

and

by

comparing

ETF

returnswiththose

on

indexfunds.

Mutual

funds are subjecttospecialized tax rules. In particular,they

must

passthrough

realizedcapitalgains to theirshareholders.

Dickson

and

Shoven

(1995)

and

Dickson, Sialm,

and

Shoven

(2000)

emphasize

that this raisesthe tax

burden

on

mutual

fund investorsrelative tothe

shares, buy-and-holdinvestorsinan equity

mutual fund

may

become

taxable

on

the fund's

realizedcapital gains.

Exchange

traded fundsare technically

mutual

funds, so they are

governed

by

the

same

taxrules,but they

have used

a technique

known

as

"redemption

inkind"

tosubstantially reduceor

even

eliminatetheir distributionsofrealizedcapital gains. This

accounts for their historicaltaxadvantage relative to

many

traditionalequity

mutual

funds.

1.

The

Mechanics of

Exchange

Traded

Funds

ETFs

aretraded securities. Gastineau (2001,

2002)

providesaverydetailed history of

boththe history

of

ETFs, and

thecurrentoperation

of

theseproducts.

The

first

ETFs

were

traded

on

the

American

Stock

Exchange,

although

ETFs

are

now

traded

on

the

New

York

Stock

Exchange

as well.

Each

ETF

shareis aclaim

on

atrustthatholds aspecifiedpool

of

assets.

The

SPDR

trust,forexample, holdsthestocks in the

S&P500.

ETF

shares arecreated

when

an

authorized financial institutiondeposits a portfolio

of

securitieswiththe trustee

and

receives

ETF

shares inreturn.

These

ETF

shares

can be

soldtootherinvestors.

The

market

for

ETF

sharesoperateslikethe

market

forshares

of

a

common

stock. Investorscan

buy

orsell

ETF

sharesat

any

pointduringtheday.

ETF

share prices

may

diverge

from

theunderlyingnet asset

value

(NAV)

ofthe securitiesheldinthetrust,although such divergenceisrestricted

by

the

capacityofauthorized financialinstitutionsto create

and

redeem

ETF

shares. Ifthe

ETF

share

pricerises toofar

above

the

NAV

fortheunderlyingassets,the creatinginstitutionswill

buy

the

associated securities,deposit

them

inthetrust,

and

create

new

ETF

shares. Ifthe

ETF

share

pricefalls

below

the

NAV

of

theunderlyingassets,institutions will purchase

ETF

shares

and

redeem

them

forthe underlyingsecurities.

ETF

shares

must be

purchased through brokeragefirms,

which

entails

commission

costs.

They

can

be

purchased

on

margin and

sold short.

These

features, aswellas the opportunityto

funds.

Mutual

funds can only be

bought

or sold attheir end-of-daynetassetvalue. In

many

casesthey can

be

purchased without

any commission,

directly

from

the fund

complex.

Mutual

fundshares cannot

be

sold short or

bought on

margin.

These

differencessuggestthat

ETFs

and

mutual

fundshares

may

be

appropriate for differenttypesofinvestors:

ETFs

forinvestors

who

demand

short-term liquidityand

who

buy

inlarge lots,equitymutual fundsforinvestors

who

make

many

small purchasesorsales

and

who

placelessvalue

on

liquidity.

The

foregoingdifferencesnotwithstanding,

ETFs

are similarto

mutual

fundsin

many

ways.

Both have

operatingexpensesthatreduceinvestorreturns.

Most

ETFs

to date

have been

designedto track aspecifiedmarket index, sotheyaresimilartoequity indexfunds.

Both

ETFs

and

indexfunds

may

experience

some

"tracking error"in

matching

thepre-tax return

on

the

index.

ETF

and mutual

fundscandifferin their

expense

ratios, theirtracking error,and,because

ofthebid-askspread

on

the

ETF,

inthe relationship

between

theirpurchaseprice

and

the net

assetvalueoftheunderlying indexsecurities.

On

an after-tax basis, differences incapital gain

realizations

between

ETFs

and

equity indexfunds

may

alsoleadto differencesin returns.

Table 1 presentsinformation

on

the

growth

of

ETFs,

equityindex funds,

and

allequity

mutual

funds duringthe lastdecade.

The

first

column shows

that

between

1993,

when ETFs

were

firstintroduced,

and

2000,the assetsheld

by

equity mutual fundsroseroughlyfive-fold.

Over

the

same

period, theassets

of

domesticindex fundsrose

by

a factoroffifteen. Index funds

representedthreepercent

of

theassets inequity

mutual

funds in 1993,

compared

withnearlynine

percentin2000.

The

growth

in

ETFs

is

even

more

dramatic.

ETFs

had

virtually

no

assets in

1993, but

by

year-end 2000, theyaccounted for 1.7percentofequity

mutual fund

assets. This

share

had

grown

to 2.3 percent

by

November

2001

.

ETF

assetsarehighlyconcentrated.

Table

2

shows

thatatthe

end

of 2001, eight

ETFs

and

the

NASDAQ

100trust(ticker

symbol

_QQQ)

trust,accounted for

more

than $51 billion in

ETF

assets,ornearly three quartersofthetotal. Table2 also

shows

thatthe

expense

ratios

charged

on

the largestfunds vary

from

nine basispoints(iShares

S&P500)

to

28

basispoints

(SPDR

Technology). In general, the

expense

ratios

on

ETFs

thatinvestinspecific industries or

inindicesthatinclude

non-U.

S. stocks arehigher thanthe

expense

ratiosfor

ETFs

thathold only

domesticsecurities.

The

expense

ratios for

most of

the large

ETFs, however,

are substantially

below

the

expense

ratiosforequity

mutual

funds,

even

thoseforindex funds.

Data compiled

by

theInvestment

Company

Institute suggestthatin 1998,theasset-weighted average

expense

ratio

fordomestic equityindexfunds

was 24

basispoints (0.24 percent)peryear.

2.

Comparing

Returns

on

ETFs

and Index

Funds

To

illustratethe differencesinthebefore-tax

and

theafter-taxreturns

on

ETFs

and

traditionalequity

mutual

funds,consider a taxable investor

who

faces a taxrateofTd

on

dividend

income and

xcg

on

realizedlong-termcapital gains.

Assume

thatallrealized gains arelongterm.

For

investors

who

do

notliquidate theirholdings, thepretax return(R)

on

both

ETFs

and mutual

funds consist

of

threecomponents:

R

=

d

+

g

+

u. Inthisexpression,

d

denotesdividend income,

g

denotesrealizedcapitalgainsdistributed

by

the

ETF

or the fund,

and

u

denotesunrealizedcapital

gains. All three

of

thesereturn

components

are

measured

aspercentages

of

thebeginning

of

period

value

of

the

fund

or the

ETF. For

the

fund

this

would

be measured

using

NAV,

whileforthe

ETF,

the initialvalue could

be measured

usingeither

NAV

or the

market

priceof

ETF

shares.

Table3presentsinformation

on

thereturntoholdingan

S&P500

portfolio

by

holdingthe

SPDR

exchange-traded fund

and

by

holdingtheretail

Vanguard

Index

500

fund.

The

tablealso

shows

the returns

on

the indexitself.

We

consider theretailversionofthe

Vanguard

indexfund,

We

calculatereturns

on

the

SPDR

trust in

two

ways.

The

first

measures

annual

undistributedcapital gains as the difference

between

thenetassetvalueofthe

SPDR

trust atthe

beginning

and

attheend ofthe year.

The

second measuresundistributedcapitalgainsasthe

difference

between

theclosing pricesforthe sharesinthe

SPDR

trustoverthe

same

period.

The

NAV

and

closingpricecandiffer forthe

ETF.

Table3

shows

that

on

average, thetotalpretax

returnfora

SPDR

trustinvestor

was

16or 17 basispoints,

depending on

our

measure

of

undistributedcapital gains,

below

the return

on

the

Vanguard

Index 500. Thisfundinturn

had

an

averagereturnthat

was

sixbasispointslower thanthe return

on

the

S&P

500

Index.

The

return

differential

between

theindex fund

and

the indexis smallerthanthe indexfund'sexpenseratio.

Thisindicatesthatthe

Vanguard

Index

500

fund outperformedthe index during oursampleperiod.

The

superiorperformance

of

the indexfund

may

be

due

tovarious tradingstrategieswithpositive

averagereturns, suchaspurchasingsharesin

companies

thatarebeing

added

tothe

S&P

500

when

theiradditionis announced,rather

when

theaddition actually takesplace.

The

22

or23basispointshortfall

between

theaveragereturn

on

the

SPDR

trust

and

the

return

on

the

S&P

500

Indexis explained

by two

primary factors. First,the expenseratioforthe

SPDR

exchange

tradedfund averaged 17 basis pointsoverthe seven-yearperiod

we

consider.

Second,

when

an

ETF

receivesdividend payments, they areheldinanon-interest-bearingcash

accountuntilthe

end

of eachquarter,at

which

pointthey are distributed toinvestors. Elton,

Gruber,

Comer, and

Li (2000) observethatinarisingmarket, likethatexperiencedduring

much

of

our

sample

period,thedelayinreinvestingdividendswillcausethereturn

on

the

ETF

tofall

below

that

on

the

market

indexor

on

index fundsthatreinvestdividends immediately.

The

calculationsinTable3 suggestthattheaveragereturn

on

the

SPDR

trusthas

been

closetotheaveragereturn

on

the

S&P

500

index,

and

thatithas

been

within twentybasispointsof

closertotheaveragereturn

on

allindex funds, since otherretailindex funds

have

higherexpense

ratiosthanthe

Vanguard

Index 500.

The

disparity

between

the

ETF

returnandthe indexfund

return

would

be larger if

we

consideredan institutional indexfund,suchas

Vanguard Admiral

shares,

which

chargeanexpenseratio

of

12 ratherthan 18 basispoints.

Table3

shows

thatwhiletheaveragereturn

on

the

SPDR

trusttracksthe average

S&P

500

return,therearenon-trivialyear-to-yeardifferences.

The

difference

between

the closing priceand

the

NAV

on

ETFs

cangenerate differences

between

the

ETF

returncalculatedusingclosing prices

and

the return

on

theindex fundorthe

S&P

500

index. In 1999,forexample,there

was

nearlya

60

basis point difference

between

the

ETF

return calculatedusingclosing prices

and

thatcalculated

usingthe netassetvalueatthebeginning

and

end

oftheyear.

3.

Taxes

and

TransactionsCosts

The

current-yearafter-taxreturnforabuy-and-holdinvestorineitheran

ETF

oran index

fundis

R

at

=

(1-Td)*d

+

(l-xcg)*g

+

u. Bergstresser

and

Poterba (2002)notethatunrealized gains

in factfaceataxburdenthat inpresentdiscountedvalueis

some

fractionofthecurrentstatutory

taxrate.

Assuming

azero taxrate

on

undistributed gainsprobablyoverstates theeffective after-tax

return differences

between

the

SPDR

trust

and

the

Vanguard

Index500.

The

averagecapitalgaindistribution

on

the

SPDR

trust,asapercentage

of

the

beginning-of-yeartrustvalue,has

been

three basis pointsperyear overthe

1993-2000

period.

For

the

Vanguard

Index

500

fund,the averagecapitalgaindistributionhas

been 48

basispoints.

For

a

taxable investor facing a

20

percentmarginal taxrate

on

realizedcapitalgains,theafter-taxreturn

on

theindexfund

would

be reduced,relativetothat

on

the

SPDR,

by

roughlynine basispoints.

Table

4 shows

the before-tax

and

theafter-taxgeometric

mean

return

on

boththe

SPDR

and

the

Vanguard

Index

500

fund overthe

1994-2000

period. Beforetax,thereturn

on

the

from

thevalueinTable3,

which

focuses

on

the arithmetic

mean

return. Foraninvestor facingan

income

tax rateof

39.6%

on

dividendincome,

and

20%

on

long-termcapitalgainrealizations, the

after-taxreturn

on

the

Vanguard

Index

500

is 17.2 basis points higherthanthat

on

the

SPDR

trust.

Ifthe investor facesalower marginal taxrate,

28%

on

ordinaryincome,then the returndifferential

is 17.9basis-points infavorofthe

Vanguard

Index

500

fund.

These

modest

differencessuggest

thatthehigher tax

burden

associatedwiththegreatercapitalgaindistributions

on

the Index

500

fund,relative tothe

SPDR

ETF,

do

notreducethe after-taxreturn

by

enough

to

outweigh

the

pretax returnadvantageoftheindexfund.

The

capitalgaindistributions

of

the

Vanguard

Index

500

fundarevery

low

by

comparison

toother equitymutualfunds,

and even

by

comparison

to

otherindexfunds. If

we

compared

the

SPDR

withotherindexfunds, theafter-taxreturnbenefits

of

low

capitalgaindistributions

would

be

magnified.

The

calculations inTable

4

do

not include allofthepotentialcoststhat

an

investor

might

faceinpurchasing an

exchange

traded fund. Investors

must pay commission

chargestoabroker

when

they

buy

orsell

ETFs.

Inaddition,thebid-askspread

on

ETFs

raisestheround-trip

transactioncost. Forthe

1994-2000

period,theaveragedifference

between

thebid

and

askprices

for the

SPDR

trust,asapercentage

of

themidpointofthepricerangeforeachday,

was

0.096

percent(9.6basispoints). This spread

would

essentiallyrepresent aone-timechargeassociated

withtradingin

ETFs.

Commission

charges should

be viewed

in the

same

way

-

a one-timecost

thatreducesthe return

on

the

ETF

investment.

We

have

nottriedtocalculatethe effectofthese transactioncosts

on

the internal rate

of

return

on

the

SPDR

trustrelative to that

on

the

Vanguard

Index 500. Ifaninvestor

were

holding

the

SPDR

trust foronly a single year,thenthe return

would

be

reduced

by

theaverage bid-ask

spread, or

by

another 9.6 basispoints.

Commission

costs

would

furtherreduce thereturn,but the

periods,thetransaction cost associatedwiththebid-askspreadhasa

more

muted

effect

on

the

internal rateofreturn.

4. In-Kind

Redemptions and

After-Tax Returns

The

SPDR

trusthas distributed

fewer

capitalgains than the

Vanguard

Index

500

over our

sample

period.

The

differencein capital gain realizationrates

between

ETFs

and

equity

mutual

fundshas

more

generally

been

a

key

component

of

the marketing claimthat

ETFs

are "tax

efficient" relative to

mutual

funds.

The

experience ofthe

SPDR

trustisnot representative

of

all

ETFs

—

many ETFs

have

distributedcapital gainsin recentyears.

However,

the

way

ETF

shares

arecreated

and

redeemed

provides

ETFs

witha

means

to

lower

theircapitalgainrealizations

relative to

some

traditionalequity

mutual

funds.

When

arbitrageurs

redeem

ETF

shares

from

thetrust,thetrusteehasthe optionof

distributingtheunderlyingsecurities that

comprise

the index, ratherthancash,tothearbitraguer.

Thisis

known

as "redemption inkind,"

and

itis a strategythatis availabletoallinvestment

companies

operating

under

theterms

of

the Investment

Company

Act of

1940. Traditional

equitymutual funds canalsoutilize

redemption

inkind, although they

have

historically

used

this

optionrelativelyinfrequently.

The

greateruse

of

thisstrategy

by

the

ETFs

reflectsinparttheir

greaterfrequency oflargetrades,asarbitrageurs create

and

redeem

trustshares.

Redemption

inkindoffersthe trustee theopportunitytoreducethevalue

of

unrealized

capitalgainsheld withinthe

ETF

trust.

When

thetrusteedistributes securities,

he can choose

to

distribute securitieswith substantial

embedded

capitalgains.

When

an

arbitrageur

redeems

$100,000 of

ETF

sharesfor

$100,500 of

underlyingstock, thecapital gainforthe arbitrageuris

$500. This istrue

even

ifthe

ETF

distributesabasketofsecuritieswith a current

market

value

of $100,500, buta basistothe

ETF

of

$50,000.

When

the

ETF

distributesthesesecurities witha

ETF

investors

might

faceifthese shares

were

sold,thereby triggering apass-through ofrealized

capital gains.

Thus redemption

inkind providesa

way

aroundthe

problem

of

embedded

capital

gains in

open-end

equitymutual funds.

By

distributinglow-basis stock,the

ETF

reduces the

likelihood thatitwill at

some

point

need

to sell low-basis stock

and

then distributerealized

capitalgainstoits investors.

Redemption

inkindis apowerful

means

of reducing

embedded

capital gains.

As

of

September

30, 2000, forexample, the

SPDR

trustheldnetassetsof $24.29billion, capital loss

carryforwardsof $0.52billion,

and

unrealizedcapital losses of $1.06billion. Despitethe fact

thatthe trust

had

grown

through aperiod

of

substantial

market

appreciation, itapparently

had

succeededindistributingits low-basis securities

and

retaininghigherbasis holdings.

Redemption

inkindisnotthe onlyfactorleadingtodifferencesincapitalgain

realizations

between

the

SPDR

trust

and

the

Vanguard

Index 500.

Because

the

SPDR

trust

was

createdin 1993,whilethe

Vanguard

Index

500

began

tradingin the 1970s, the distributionof

purchase basesforthe securities inthe

SPDR

trustis different

from

thatinthe

Vanguard

fund.

Such

historical differencescan leadtodifferencesinrealized gains

and

after-tax returns.

5. FurtherIssues

In future

work,

we

hope

toexplore

many

issues associatedwith

exchange

traded funds.

We

hope

to

move

beyond

ouranalysis

of

the

SPDR

trustto considerthe

performance

ofother

exchange

traded funds. In

October 2001

,there

were 96 exchange

traded funds,

compared

with

79 one

yearearlier.

Many

ofthe

new

funds

have

specific investmentobjectives, suchas holding

stocksina given sector ornation,

and

they also

have

substantiallyhigher

expense

ratiosthan the

SPDR

trust.

The

mutual

fundsthatthese

ETFs

compete

witharealso likely to

have

substantially

10

A

second

issueinvolves studyingthe attractionof

ETFs

and

traditional

open-end

equity

mutual

funds fortaxable investorswith assets inbotha taxable

and

atax-deferred account.

The

low

rate

of

taxable distributions

on ETFs, and

their liquidity,

may

make

them more

attractive for

equity investments outsidetax-deferred accounts thanfor investmentsin

IRAs

or 401(k)s.

The

attributes

of

traditional equity

mutual

funds

may

make

them

more

attractive forretirement

accountinvestors.

Finally,

we

plantoconsider

how

ETFs

feature inthe

expanding

mix

of

productsoffered

by

the

mutual fund

industry.

ETFs

may

be

part

of an emerging

trend

toward

segmentation ofthe

mutual fund

marketplace,with investors

who

wish

to tradefrequentlysegregatedintodifferent

products thanlow-turnoverinvestors.

The

former

group

may

eventuallyhold funds with

substantial

expense

ratiosthatcovertheaccount

management

fees associatedwith high-turnover

investors,whilethelow-turnover, orhigh accountvalue, investors

may

be

abletoinvestthrough

funds with

much

lower

costs.

ETFs

may

attractinvestors

who

valuetheabilitytotrade

frequently,thusreducingthe turnoverrate fortheinvestors

who

continueto investintraditional

11

REFERENCES

Bergstresser,Daniel

and James

Poterba.

"Do

After-Tax Returns Affect

Mutual

Fund

Inflows?"

JournalofFinancial

Economics

(forthcoming).

Dickson,Joel

and John

Shoven. "Taxation

and

Mutual

Funds:

An

Investor Perspective," inJ.

Poterba, ed.,

Tax

Policy

and

the

Economy,

Volume

9.

Cambridge:

MIT

_{Press, 1995, pp.}

151-181.

Dickson, Joel,

John

Shoven,

and

Clemens

Sialm.

"Tax

Externalities

of

Equity

Mutual

Funds."

National

Tax

Journal

September

2000, 53 (3.Part 2),pp. 608-627.

Elton,

Edwin

J., MartinJ.Gruber,

George Comer, and

KaiLi. "Spiders:

Where

are the

Bugs?"

Mimeo,

Stern School

of

Business,

New

York

University,2000.

Gastineau, Gary.

"Exchange Traded

Funds:

An

Introduction." Journal

of

Portfolio

Management

27

(Spring2001), pp. 88-96.

Gastineau, Gary.

The Exchange

Traded

Funds

Manual

.

New

York:

John

Wiley, 2002.

Investment

Company

Institute.

"Exchange Traded Funds

Statistical Collection."

Washington,

D.C.: Investment

Company

Institute,2001a.

Investment

Company

Institute.

Mutual

Fund

Fact

Book

.

Washington,

D.C.: Investment

Company

Institute,2001b.

Investment

Company

Institute.

"Redemption

Activity

of

Mutual

Fund

Owners."

Investment

Company

Institute

Research

inBrief, 10(1),

March

2001

.

Standard

and

Poors Corporation.

Monthly

Review

.

New

York: Standard

and

Poors, various

12

Table 1: Assets inEquity

Mutual

Funds and

Exchange Traded

Funds, 1994-2001

Year

Equity

Mutual

Funds

Domestic

Equity Index

Funds

Exchange Traded

Funds

1993 740.7 22.6 0.46

1994

852.8 26.0 0.42

1995

1249.1 47.0 1.05

1996

1726.1 83.5 2.40

1997

2368.0 147.9 6.70

1998

2978.2 233.1 15.56

1999

4041.9

344.0 33.86

2000

3962.3 339.3 65.59

2001

3348.7 n.a. 78.85

Source: Authors'tabulations

based on

data

from

the Investment

Company

Institute (2001a,b).

Allentries except

2001

correspondto

December

of

the indicatedcalendaryear;

2001

data are for

November.

Table2:

Exchange

Traded

Funds

with

More

than $1.5 BillioninAssets,

December

31,

200

1

Fund

Name

Assets ($ Billion)

Launch

Date

Expense

Ratio

SPDR

Trust

(SPY)

$30.4 1/29/93

0.12%

NASDAQ

-100 Trust

_(QQQ)

21.8 3/09/99 0.18

S&P

Midcap

400

Trust

(MDY)

4.8 5/4/95 0.25 IShares

S&P

500

Index

Fund

(IW)

3.6 5/15/00 0.09

DOW

Diamond

Series TrustI

(DIA)

3.0 1/27/98 0.12 IShares Russell

2000

Index

Fund

2.1 5/22/00 0.20

HOLDRS

Biotech

(BBH)

1.6 11/22/99 * ISharesRussell

3000

Index

Fund

1.5 5/22/00 0.20

Source:

Wall

StreetJournal January7, 2002,

page

R17.

* _{denotes a}

_minimum

_expense

_ratio

_of

13

Table 3: Calendar

Year

Returns

on

S&P

500

Index Funds,

ETFs,

anc the

S&P500

Index

TotalReturn,

NAV

(ClosingPrice)

Dividend

Yield

(%

of

Lagged

Price)

DistributedCapital Gains

(%

of

Lagged

Price*

Exchange Traded

Fund (SPY)

1994

1.16%

(0.67%)

2.64%

0.00%

1995

37.22(38.10) 2.85 0.02

1996

22.70 (22.54) 2.26 0.20

1997

33.06 (33.48) 1.87 0.00

1998

28.35 (28.69) 1.46 0.00

1999

20.86 (20.39) 1.17

_L

0.00

2000

-9.15 (-9.73) 1.03 0.00

Average

19.17(19.16) 1.90 0.00

Vanguard

Index

500

Fund

1994

1.18 2.67 0.46

1995

37.45 2.84 0.30

1996

22.88 2.22 0.43

1997

33.19 1.90 0.85

1998

28.62 1.48 0.47

1999

21.07 1.24 0.87

2000

-9.06 0.96 0.00

Average

19.33 1.90 0.48

S&P

500

Index

1994

1.32 2.83 -1.54*

1995

37.58 3.00 34.11*

1996

22.96 2.42 20.26*

1997

33.36 2.09 31.01*

1998

28.58 1.67 26.67*

1999

21.04 1.36 19.53*

2000

-9.10 1.11 -10.14*

Average

19.39 2.07 17.13*

Source:

Data

underlyingcalculationsforthe

SPDR

returnat

NAV

and

forthe

S&P500

Indexare

drawn

from

the

S&P

Monthly

Review

.

SPDR

closing price returnsare

computed

from

CRSP

data.

Data on

the

Vanguard

Index

500 fund

was

collected

from

various

fund

reportsto

shareholders. * _{indicatesthat capital gains}

_on

_the

_S&P

_{500 Index}

_{aretotalcapitalgains, not}

distributed capital gains as in thecase

of

the

SPY

and

Vanguard

Index Fund.

Table 4: After-TaxReturnsfor

Taxable

Investorsin

SPY

and

Vanguard

Index 500, 1994-

2000

Return

Measure

SPY

(ETF)

Vanguard

Index

500

Difference

Before-Tax

17.982%

18.197%

0.215%

After-Tax with

39.6%

Ordinary

Income Tax

Rate

14.993 15.165 0.172

After-Tax

With

28%

Ordinary

Income

Tax

Rate

Date

Due

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