Sunny Skies for ETFs

Liquidity: ETFs are exchange-traded and are priced throughout the trading day just like any other stock. Mutual funds are priced at the close of the trading day (except for those lucky few late traders and market-timers!).

Lower costs: According to Morningstar, the average expense fee for ETFs is 0.46% and can be as low as 0.09% for highly liquid ETFs such as the iShares S&P500(IVV Quote). The average index mutual fund expense ratio is nearly double that, at 0.88%.

Transparency: The holdings of index ETFs are available on a daily basis. Meanwhile, active mutual funds generally reveal their entire holdings just twice a year.

With all these favorable comparisons against mutual funds, one might think that ETF issuers would have capitalized on the misfortune of mutual funds during the height of the mutual fund confession period in the fourth quarter of 2003.

So where were the "lipstick on the pig" ads targeting the mutual fund industry last year? Fuhr, the author of the Morgan Stanley report, says there are a myriad of reasons why ETF issuers shied away from a fight with the funds. First and foremost, the mutual fund companies are very large clients of ETF issuers. Fuhr points out the significant growth in the use of ETFs by institutional money managers: In June 2000, only 448 institutional money managers held one or more ETFs in their portfolio. In June 2003, more than 1,336 managers were regularly utilizing ETFs.

Why would a mutual fund manager use an index fund in his portfolio? Shouldn't the manager be spending his time trying to beat the index, not mimic it?

Fuhr says mutual fund and institutional money managers need ETFs for a variety of reasons, one of which is to equitize cash. For example, instead of letting cash lay fallow in a Latin American fund, mutual fund managers could put that money to work quickly and easily by picking up some iShares Latin America 40(ILF Quote) shares.

Fuhr also points out that ETFs allow fund managers to ease into a position without bidding up a stock. To use the Latin American fund as an example again, if a portfolio manager had a huge influx of cash and needed to add to his position in Telefonos de Mexico(TMX Quote) or Petrobras(PBR Quote), then he runs the risk of bidding up those shares. By buying shares of iShares Latin America 40, which contain shares of those two stocks in relevant weights, the portfolio manager can maneuver into the position without bidding against himself.

Aside from biting the hand of the institutional client that feeds them, ETF issuers chose not to attack mutual funds in public, because one side of the investment house would be feeding off the other. "A lot of people involved in ETFs are involved in mutual funds," says Jacobs. "It's different sides of the same house."

Big Year In 2003 assets under management in ETFs increased by 49% to $211 billion. Also of note:

* The average daily U.S. dollar volume traded rose 41.6% to $8.9 billion in 2003, and in terms of average daily volume of shares, there has been an 18.9% increase to 170 million shares.

* During December five new ETFs were launched -- three in Europe, one in Israel and one in Hong Kong. Two ETFs in the U.S. were delisted.

Source: Morgan Stanley