ETFs Search for a Second Act

Wall Street, like Hollywood, has a habit of over-exposing a good idea. The torrent of tech IPOs in the late 1990s, for example, closely resembled the "Rocky" franchise. The original film was an Oscar-winning blockbuster, but the artistic quality and box-office revenue diminished with each additional Roman numeral added to the title.

Wall Street's latest formula for success is exchange-traded funds (ETF) -- funds that track well-known indices such as the S&P 500 or Dow Jones Industrial Average, as well as more obscure ones such as the MSCI Malaysia index, but can be traded like a stock.

So far, ETFs have lived up to the hype, growing from 33 funds with $39 billion in assets in 1999 to 304 funds with $227 billion in assets by April 2004. An average $13 billion in the form of 230 million ETF shares now trade each day in the U.S.

Despite this amazing run, ETFs, as they now exist, are reaching the saturation point. To keep the franchise going, the industry will need to come up with significantly new flavors. Coming attractions may include new "inverse" ETFs that appreciate as stocks decline, "leveraged" funds that amplify returns and actively managed funds whose holdings change along the lines of traditional mutual funds.

In 2003, the total number of ETFs rose by just two to 282, largely because consolidation in European sector funds offset the creation of new ones. By contrast, in 2001 and 2002 the number of funds grew by 110 and 78, respectively.

And with ETFs available for virtually all of the major domestic indices as well as international ones covering countries from Mexico EWW to Spain EWP -- not to mention others spanning biotech to bonds -- there's little uncharted territory for traditional ETFs.

Even Nate Most, the man credited with creating ETFs, agrees: "The market for indexes is being sliced up so much that you are getting down to some pretty small pieces," he said.