The rise of exchange-traded funds continued in the first quarter of the year, with ETF assets swelling by $17 billion and bringing the total dollar value worldwide up to $229 billion.

Morgan Stanley analyst Debbie Fuhr says the hot first quarter of 2004 follows a banner 2003, when ETF total assets for equity products climbed to $211 billion from $141 billion in 2002. Fuhr's recent report says the number of ETFs worldwide has jumped to 302 from just three that existed 10 years ago. And ETFs saw their greatest growth spurt during the market meltdown of 2001 and 2002 and throughout the mutual fund scandal of late 2003.

Despite this spectacular growth, John Jacobs, chief executive of Nasdaq Financial Products Services, says the ETF boom is only in its earliest stages. "First there were equity index ETFs, and now fixed-income ETFs are getting started in earnest," he says. "In the future, actively managed ETFs will challenge closed-end mutual funds."

As the managing force behind the 1999 introduction of the world's most heavily traded ETF, the Nasdaq 100 Trust ( QQQ), Jacobs has the pedigree to prognosticate. Under Jacobs, Nasdaq Financial Products has launched more than 400 funds based on Nasdaq indices in more than 25 countries.

Jacobs' faith is based on the length of time it took the QQQ (commonly called the "Cube" or "Triple Q") to filter down from a high-end institutional vehicle to a security commonly found in retail investor portfolios as an inexpensive substitute for an index mutual fund. Jacobs anticipates that once retail investors become familiar with other ETFs, many of these funds will become as ubiquitous as the Triple Qs.

The retail appeal of equity-index ETFs becomes strikingly clear in the current mutual fund witch-hunt environment. Consider the benefits of ETFs compared with those of mutual funds:

  • Diversification: Like an index mutual fund, ETFs provide diversified exposure to an index, industry, sector or group of stocks. However, unlike mutual funds, ETFs do so in a single investment vehicle that can often be hedged with options.

  • Tax advantages: Unlike mutual funds, ETFs have no hidden capital gains -- taxes are owed only on gains actually realized.

  • 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 it can be as low as 0.09% for highly liquid ETFs such as the iShares S&P500 ( IVV). 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. Active mutual funds generally reveal their entire holdings just twice a year.

    With all these favorable comparisons against mutual funds, ETF issuers could be expected to capitalize on the misfortune of mutual funds during the height of the scandal in the fourth quarter of 2003. But 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 notes 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 lie 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).

    Fuhr also points out that ETFs enable 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 or Petrobras, 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."

    It's also the lower-margin side of the house at places such as Vanguard, Merrill Lynch and other issuers of ETFs and related products. The Vanguard Extended Market VIPERs ( VXF) track the mid- and small-cap index Wilshire 4500, which contains about 5,200 U.S. firms that are not 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 the company's fund income.

    Gus Sauter, Vanguard's chief investment officer, says he's not troubled by potential cannibalization. "In the end, the assets still end up in the fund. They just enter through a different door," says Sauter. Vanguard rolled out an additional 20 ETFs during the first quarter.

    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 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, because 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 brokers far more amenable to using ETFs as part of their total portfolios. Because 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 by $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) and the iShares Lehman TIPS Bond Fund ( TIP).

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