Sunny Skies for ETFs

It's also the lower-margin side of the house at places such as Vanguard, Merrill Lynch(MER Quote) and other issuers of ETFs and ETF-style products. The Vanguard Extended Market VIPERs(VXF Quote) tracks the mid- and small-cap index Wilshire 4500, which contains about 5,200 U.S. firms except those in the S&P 500. Expense ratios for the VIPERs run an investor 0.20%, while expense ratios for buying the fund directly are 30% higher at 0.26%.

It's difficult to quibble with Vanguard over 6 measly basis points, but the point is clear that promoting ETFs might cannibalize its fund income.

Gus Sauter, Vanguard's chief investment officer, remains untroubled by potential cannibalization. "In the end, the assets still end up in the fund. They just enter through a different door," says Sauter. He adds that Vanguard will be rolling out an additional 20 ETFs within the next two months.

Right now, the only door for investors looking to purchase an ETF is through a retail broker's office, so Sauter doesn't have to worry about internal Vanguard vs. Vanguard conflicts too much. Retail brokers who like to sell high front-end-loaded mutual funds to clients, however, might want to keep the growing ETF chatter down. But they, too, have a buffer, since the majority of investors buy their mutual funds directly from the issuer in their 401(k) plans, and their stocks elsewhere.

Retail investors whose funds are managed as part of a wrap account program might find their broker far more amenable to using ETFs as part of their total portfolio. Since the broker is being paid for assets under management as opposed to a per-trade basis, there is no conflict of interest regarding fees or performance.

When it comes to performance, Fuhr spotlights the most logical reason for owning an index-based ETF. "If most active fund managers don't outperform the index, investors should just buy the index in the form of an ETF."

Nonetheless, Lee Kranefuss, CEO of Barclay's iShare ETF business, points out the one downside of small investors' employing ETFs as a fund substitute. "Because the trades are done through a commission-based brokerage house, it's probably not prudent for small investors to keep paying commissions as they dollar cost average into an ETF," says Kranefuss. "The cost of getting in is too high."

Kranefuss might not have a problem steering small investors away from ETFs, but in 2003, the investing world definitely found Barclay's iShares products. The U.S. iShares family grew 72%, or $24.5 billion in assets, in 2003 from $34 billion to $58.5 billion. And there are 84 U.S. iShares, of which the newest ones are the iShares Dow Jones Select Dividend Index Fund(DVY Quote) and the iShares Lehman TIPS Bond Fund(TIP Quote).

That's not a bad performance right there.