Slowdown May Help ETFs Speed Up

Some market watchers say the funds will become even more popular in an economic downturn.
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After years of strong growth, exchange-traded funds are beginning to experience backlash.

Media stories have been popping up that speculate whether there are

too many ETFs, whether they are too specific and whether they can offer real value if they are not actively managed.

But a true test of the funds' worth may come if the economy hits the skids. And some ETF experts speculate that a downturn will push even more money into the funds.

"People tend to change paths when they feel they've

been burned," says David Abner, managing director of ETF trading at BNP Paribas. "If there is a serious market decline and people lose a lot of money they may be somewhat shy about just putting money back into mutual funds when things turn around. They'll be looking for new ways to invest, and ETFs will benefit from that desire."

While the theory that ETFs will prosper in a downturn isn't cut and dried, there is ample evidence to support Abner's claim that investors dump mutual funds when markets dive. According to the Investment Company Institute, mutual-fund inflows totaled $228 billion in 1993, and then dropped to $84 billion in 1994 when markets declined. Similarly, inflows hit $504 billion in 2001, fell to $74 billion in 2002 and sank to a negative $43 billion in 2003.

Of course, the debate about whether the economy is currently in a slowdown is ongoing. But with the real estate market in a clear downturn, oil prices soaring and second-quarter GDP rising at a slower-than-expected 2.5%, the running of the bulls might slow down at any time. And while the markets may be celebrating over speculation that the

Federal Reserve

has seen the economy cool enough to stop raising interest rates, data from Ned Davis Research shows that stocks, on average, have lost nearly 4% in the year after Fed rate hikes ended.

Ronald DeLegge, publisher of the Web site ETFGuide.com, says there are reasons to believe that ETFs are structurally better able to weather a downturn.

"With mutual funds, the main problem you have as a shareholder in a declining market is that the fund manager is often forced to liquidate holdings within the fund as more people redeem their shares in a very severe market," says DeLegge.

He says that this can create a difficult situation for a fund manager because it may be inopportune to sell holdings as the market declines.

Moreover, the tax and fee structures at a typical mutual fund add to the financial burden borne by investors who choose not to leave the fund. If the manager has to sell shares of the underlying stocks within the fund, it adds transaction costs and could create unwanted tax liabilities for shareholders who wait out a stock market slide, DeLegge adds.

"The important factor here is that it is becoming more difficult to obtain double-digit or even decent returns, and more investors are realizing they need to focus on things they can control to boost their returns. This includes how much they pay in fees to have their money managed," he says.

Abner points out that recent explosive demand for ETFs has been attributed in part to the fact that they deliver similar performance returns as indexed or select mutual funds, for lower fees. They also offer advantages like real-time prices and electronic access. They also have "new product cache," he adds.

Because ETFs are seemingly easier to understand and less costly than mutual funds, investors who pull money out of their funds in a market downturn may put that to work in an ETF when they jump into stocks again, Abner says.

"The explosion of online trading, electronic access, and government regulations is really changing the way people manage their money," Abner says.

DeLegge also points out that the price wars among online brokerages have helped reduce trading commissions, to the benefit of ETF investors.

"

There has been and will be massive growth in all the ETF products over the next decade. There is so much demand for new products and different types of ETFs ... I would only see that demand increasing from a retail perspective if we were to enter a new bull-market phase at some point in the future," says Abner.

However, Jeff Tjornehoj, senior research analyst at Lipper, says an economic slowdown won't provide the crucible needed to end the debate over whether ETFs are a wise investment.

"Investors going in don't discern a difference in opportunity between mutual funds and ETFs, because they are essentially the same product. They are just baskets of stocks. So if a market event happens that sours investors on stocks, it will affect all stock-related products," he says.