The number of institutional investors holding one or more U.S. listed exchange traded funds (ETF) grew 6% during the past year from 1,336 to 1,413, according to a Morgan Stanley report released today. Over the past four years, the the number of worldwide institutional users has increased 215%.

"Many mutual funds have embraced the idea that ETFs are tools that can help them manage cash, or implement a short strategy," says Debbie Fuhr, Morgan Stanley's London-based ETF specialist. "They also can be used to gain exposure to sectors, styles, country or international markets at real-time prices during the day."

The report says ETF use by hedge funds increased by 13% over the past year. The number of hedge funds using U.S. ETFs has risen to 104 from 92 since last June.

The number of European institutions using U.S. listed ETFs dipped slightly to 287 from 295. During the prior three years, however, European funds readily embraced U.S. ETFs as usage skyrocketed from 32 in June 2000. The report says the countries with the greatest institutional interest in U.S. ETFs over the past year were Greece, up 80%, and Sweden, up 67%.

At the end of June, there were 304 ETFs worldwide with assets of $246 billion. The U.S. had the largest number of ETFs at 134 with a market capitalization of $178 billion.

The most widely-held U.S. listed ETFs by institutions were the SPDR S&P 500 ( SPY)and the Nasdaq-100 Index Tracking Stock ( QQQ) at 784 and 567 respectively.

The report also predicts that the use of ETFs by mutual funds in the U.S. and Europe "should increase in both number of users and amount invested during this next year" based on recent decisions by the Securities and Exchange Commission in the U.S. and the European Union Central Bank.

In the U.S., a number of managers have received exemptions from the SEC over the past fourteen months allowing them to invest in ETFs in excess of the limits previously set by the Investment Company Act of 1940. The law prohibits a fund from investing more than 5% of its total assets in a single investment company or acquiring more than 3% of another investment company. Since ETFs are regulated like mutual funds under the 1940 act, fund managers previously could not raise their stakes above the original levels.

In Europe, the central bank decided in October 2002 to allow funds to raise their ETF positions provided they meet certain holding criteria.

A potential drawback to the trend of mutual funds increasing their ETF stakes is that it creates a greater temptation for fund managers to become "closet indexers" says Ron DeLegge, publisher of EtfMarket.com.

"The investment manager might be outperforming an index through the year, but then take money off the table in September or October to buy the ETF that matches his benchmark," says DeLegge. "That's a secretive strategy that allows fund managers to play it safe at the end of the year to meet their own performance targets. But it is not always in the best interest of the shareholder who can be paying a significant fee for their money to be managed."

Kunal Kapoor, director of fund analysis at Morningstar, however, says investors should not be concerned that the growing attraction of ETFs will boost the number of closet indexers.

"Closet indexers have many tools to use and this is just another one," says Kapoor.