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Exchange-Traded Funds Continue to Grow in 2001

Lee Barney

When the number of exchange-traded funds -- mutual funds based on equity indices that trade like a single stock and can be bought or sold intraday -- first began taking off two years ago, an all-out media frenzy ensued.

ETF assets multiplied 10 times from $6.7 billion in January 1998 to $66 billion as of the end of March 2001. Some predicted that assets in this new type of mutual fund would swell to as much as $500 billion by 2005. Others went so far as to say ETFs could overtake traditional equity mutual funds in popularity.

While the hoopla over ETFs has died down somewhat and their assets are now only projected to reach $200 billion by 2005, ETFs have continued to be popular, even during the recent market downturn. During the past year, ETFs have had $42 billion in net inflows, compared with net outflows of $80 billion for equity funds, according to the Investment Company Institute. And in March, ETFs reaped $8.9 billion in inflows, while equity mutual funds lost $20 billion.

What's more, nearly 40 more ETFs are scheduled to be introduced in the U.S. and abroad in the near future, adding to the 83 ETFs currently on the market. The Singapore Exchange and the Australian Stock Exchange are two of the first foreign exchanges to list ETFs, and many more exchanges are about to offer ETFs in an effort to build volume.

While assets in ETFs still only represent a very small portion of the almost $4 trillion in assets under management in all equity funds, ETFs have an undeniable appeal. Investors apparently like the way that they combine the low-cost, tax-efficient exposure of index funds with the trading flexibility of stocks.

Getting Exposure

The first and foremost reason investors like ETFs is because, like index funds, they offer exposure to a variety of sectors -- be it a broad index like the S&P 500, on which State Street Global Advisors' spider (S&P Depositary Receipt) is based, or a specific index like the Barclays' iShares Mexico fund. "We are finding that fee-based advisors are liking ETFs as an asset-allocation tool," says Gregory Ehret, a principal with State Street, which sponsors 20 ETFs.

Institutional investors also like ETFs as a way to gain exposure to a particular index or sector without having to make individual investment decisions, says Brad Zigler, a principal with Barclays, which offers 61 ETFs. Portfolio managers can buy an ETF and later decide which individual stocks they want to own, he says.

Many investors are buying ETFs right now to take advantage of what they see as the bottom of the market. "Our iShares have been continuing to grow like wildfire," says Ehret. "We have seen assets increase far more than you would expect in a down market."

The biggest ETF of them all is the QQQ (QQQ Quote), or cube, which is based on the Nasdaq 100 index. Even though it's down 68% over the past year, the QQQ has continued to attract tremendous assets. It currently has $24 billion of assets under management and is trading an average of 80 million shares a day. In the fourth quarter alone, the QQQ attracted a whopping $18 billion in net new cash, according to Strategic Insight, a mutual fund consultancy.

Low Fees and Flexibility

Investors also like ETFs because their fees can be even lower than index funds'. ETF fees start as low as nine basis points and can go as high as 70 basis points, says Gavin Quill, senior vice president of Financial Research, a fund research company. Index fund fees, on the other hand, average between 20 and 80 basis points, and actively managed funds have fees ranging from 1.3% to 2.5%. Even though ETFs must be bought or sold through a broker, and so incur trading costs, these are generally offset by the lower fees charged by ETFs, according to Quill.

ETFs also differ from index funds because they allow investors to trade in and out of them during the day. This can affect returns by more than 1%, Zigler says. For instance, if an investor in an index fund tracking the S&P wants to sell his or her shares, the investor will only be able to do so at the closing net asset value price of the fund, Zigler says. But in an ETF tracking the S&P, the investor can get whatever price the index is trading for at that moment.

"Because the S&P 500 rises or falls an average of 140 basis points a day, the index fund investor incurs a 140 basis-point risk that they will not get the price that they think they are getting when they make the decision to buy or sell an S&P 500 index fund," Zigler says. But in an S&P ETF, the investor incurs only a three basis-point risk because that's how quickly these orders are processed, he says.

In addition, a big difference between ETFs and index mutual funds is that ETFs allow investors to sell them short or buy on margin. Many ETFs also have put or call options, which are very popular, says Cliff Weber, senior vice president of new product development at the American Stock Exchange, which currently lists all U.S. ETFs. In some cases, institutional investors prefer ETFs to futures because ETFs don't have the margin requirements or expiration dates that futures do, says mutual fund consultant Geoffrey Bobroff.

Finally, ETFs have limited embedded capital gains taxes because the specialists who handle them redeem shares in like kind with a counterparty. However, they do incur some capital gains because they are tied to indices and managers have to rebalance their holdings whenever the index is changed, which in some cases can occur quite frequently.

Despite these advantages, though, there are some who don't believe that exchange-traded funds will ever make significant inroads with retail investors.

"They're not sexy enough," says Michael McDonald, a senior vice president with Salomon Smith Barney. McDonald compares ETFs to index funds, which he says have never become particularly popular despite having been around for 25 years (currently, index funds account for about 8%, or $319 billion, of the $3.961 trillion in assets under management in equity funds, according to Morningstar). With $66 billion in assets, ETFs have less than 1% of the $7 trillion invested in all types of mutual funds.

Waiting for a Rebound

Others feel that once the market recovers, ETFs will regain attention. "The uneven market environment we have been in has caused some retrenchment" away from equity investing, Bobroff says. "Once we get back to a normalized market, exchange-traded funds will again become a focal point. While we have seen a dampening of excitement, these products are still poised for growth," he says.

Of the 40 new ETFs about to be introduced, Nuveen Investments is planning five fixed-income ETFs. Vanguard is planning one based on the Wilshire 5000 index and another on the Russell 2000 index. ProFunds hopes to offer as many as a dozen ETFs based on their leveraged index funds. And State Street Global Advisors is about to introduce 14 new ETFs in Europe and Asia.

More exchanges are looking to offer ETFs, as well. The American Stock Exchange is currently the only U.S. exchange to offer ETFs, but the New York Stock Exchange has announced plans to cross-list ETFs. Foreign exchanges are also jumping on the ETF bandwagon. Amex recently formed a joint venture with the Singapore Exchange and began cross-trading five Amex-listed ETFs on May 4.

"Over the next two years, we expect several new countries and new exchanges to begin offering their own ETFs. We are also looking for many new sponsors, and a blizzard of new products and cross-listing from established participants," says Financial Research's Quill.

But the low fees that these funds charge will force some to close because they won't make enough money to cover their costs, predicts mutual fund consultant Burton Greenwald. Detractors also point out that some of the niche ETFs are based on esoteric indices that are thinly traded, which can lead to wide bid /ask spreads and, therefore, unfavorable pricing. The iShares Dow Jones Basic Materials fund, for instance, traded an average of just 5,700 shares a day in April.

But in the end, ETF sponsors may prove to be just as adaptable as their equity fund colleagues in coming up with products that investors want.

"There remains a great deal of opportunity for new innovations and product extensions into fixed-income, leveraged and enhanced ETFs, with eventually even an actively managed version," says Quill.