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Are exchange-traded funds the financial wave of the future?

The popularity of this low-fee, passively-managed security that mirrors a stock market index, has been taking the U.S. and Canadian markets by storm. In the U.S., the investment product has grown from nothing from its 1993 introduction, to more than $50-billion (U.S.) in assets under management so far this year. Until recently, the only ETF product in Canada was iUnits, or i60s, sold through Barclays Global Investors. The hugely successful product that tracks the S&P/TSE 60 index, has grown to $6.5 billion in Canadian assets since its debut in October 1999.

Now State Street Global Advisors has entered the Canadian market, offering a Dow Jones Canada product comprised of 40 of Canada's large, blue-chip companies. Nathan Most, the 86-year-old father of exchange-traded funds, and chairman and president of the U.S. product, iShares Funds, and consultant to Barclays Global Investors, had this to say about ETFs during a recent visit to Toronto: "The ETF will gradually replace the mutual fund - perhaps not entirely, but at least in part." There is confusion over the product itself. Part of the confusion lies in the language - industry terms such as TIPs, HIPs, i60s, iShares, iUnits, or index participation units - all refer to index-based securities. In a nutshell, the difference lies in the mechanics: how they are sold, who sells them, what they call them, and what index benchmark they track. Exchange-traded funds, while similar to index mutual funds - in the sense that they mirror a particular stock market index - are mechanically, two very different products. Most simply, one is sold as a stock unit, the other is sold as a mutual fund.

Exchange Traded Funds (ETFs)

The mutual fund index-based product

Advantages of ETFs versus index-based mutual funds

Risks of ETFs and index-based mutual funds

As with any financial product both ETFs and index-based mutual funds are subject to volatility. As both products mirror their underlying index, they can be more volatile then actively managed funds which may have the ability to put a certain percentage of assets in cash when market conditions warrant. One glance at the financial pages recently underlines this point. In August, for example, the returns of index funds were in the top quartile of the Canadian equity fund category. Just one month later, when the overall market weakened, the index-fund stars were "down in the basement."