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.
In addition, none of the recent ETF offerings have remotely challenged the older, more established funds. Only the two most well-known ETFs, the SPDR Trust ( SPY), which tracks the S&P 500, and the Nasdaq-100 Trust ( QQQ), which tracks the top 100 Nasdaq stocks regularly and makes the list of the 10 most-heavily traded shares. The SPDR -- also known as the "Spider" -- has an average daily volume of 47 million shares, while the Nasdaq-100 Trust -- commonly called the 'triple Q' -- turns over 112 million shares a day. The pair account for an inordinate 80% of the total trading volume of ETFs. (To put that in perspective, Microsoft ( MSFT) alone turns over almost 66 million shares a day, while Lucent's ( LU) average daily trading volume is more than 47 million.) But the Spider has now been trading for more than 10 years and the QQQ celebrated its fifth anniversary on the American Stock Exchange this past May. And despite the creation of dozens of new funds, the top five ETFs still represent 60% of the group's total assets. ETF investors have been waiting for new products to take the burden off both the 'Spider' and 'QQQ', but so far not one has proven up to the test. The best hope for the next generation of funds is actively managed ETFs, but that's been an elusive product for analysts and investors seeking a way to trade their favorite fund like a stock. The biggest sticking point remains the possibility of price disparities -- or arbitrage opportunities -- developing between the underlying value of the assets held by the ETF and the price at which the fund trades. Still, obstacles aside, some say their day will come. "Somebody of importance has to take the first step," says Most.
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.
"There is a tendency for people to want to beat the market," says Cassidy. "And traditional mutual funds do have a few advantages over ETFs. For example, it's easier to reinvest distributions in an open-end fund and dollar-cost averaging can get expensive with ETFs because they charge a commission for each trade."
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.