How We Got Here"Index ETFs are absolutely saturated," says Kevin Ireland, vice president of ETF marketing at the American Stock Exchange. "I think we've covered all the benchmarks." Chris Hughen, finance professor at Bowling Green State University Finance, is less generous. "We need another ETF that tracks a large-cap stock index like we need another reality TV show." That said, ETFs still claim a tiny share of the market compared to mutual funds and future growth will be difficult without alluring new products, even with their inherent advantages. Lower expenses are clearly an advantage compared to open-end mutual funds. The average actively managed domestic equity fund and domestic equity index fund carry expense ratios of 1.52% and 0.75%, respectively, while the average broad market equity ETF carries a fee of .32%, according to fund tracking firm Morningstar. "I happen to think the asset growth of ETFs has the potential to seriously rival open-end mutual funds," says Ron DeLegge, publisher of ETFmarket.com. "There's too much money in the U.S. still sitting in underperforming actively managed funds." According to Morningstar, the majority of open-end funds underperformed their benchmarks over a 10-year period after accounting for fees and taxes. In the case of large-cap funds, only 2% of large-cap value, 5% of large-cap blend and 12% of large-cap growth managers outperform their benchmarks. And in the fixed-income category, less than 15% of active managers outperformed their respective benchmarks over the last 10 years. Paul Mazzilli, ETF specialist at Morgan Stanley, says the tax benefits of ETFs have helped them outperform actively managed funds. "They tend to pay out less taxable gains distributions, which can erode returns, than actively managed funds," says Mazzilli. Nevertheless, some analysts remain skeptical when they hear about the limitless growth potential of ETFs. Don Cassidy, senior analyst at Lipper, points out that roughly 11% of all open-end mutual fund assets are held in index funds and only 2% to 3% in ETFs. Open-end index funds have been available since 1976 and ETFs since 1993 -- a period more than long enough for investors to have discovered the benefits of indexing.
ETFs: The Next GenerationFor many, the next big thing will be actively managed funds. The big question is, when? "Fund companies are waiting for somebody else to make sure the product is safe before they piggyback on it," says Ireland of the Amex. "They each want somebody else to take it through the Securities and Exchange Commission and onto the market before stepping up." So, what's left? An ETF tracking the price of gold, for example, is currently under review by the SEC, and other commodity-based ETFs are sure to follow if it proves successful. Gary Gastineau, managing director at ETF Consultants, says the next ETF expansion will be relatively small with inverse and leveraged ETFs leading the way. Inverse ETFs return the opposite (inverse) of a current benchmark or index and leveraged ones use derivatives to offer returns in excess of the benchmark. Hughen says investors should be on the lookout for additional ETFs that track the indices of developing countries, especially with the current obsession over the economies of China and India. "The next wave of ETFs will not be actively managed funds, as some seem to think," says ETFMarket.com's DeLegge. "Rather, we think it will be with 'semi-active funds', or funds that take established indices to the next level of portfolio management." An example of a semi-active fund is the Powershares Dynamic Market Portfolio ( PWC), which attempts to mirror the performance of the sophisticated "Intellidex" index developed by the American Stock Exchange.