ETFs: What New Trends Mean for Investors

After experiencing rapid growth and adding so many new variations in recent years, the ETF industry is ripe for consolidation

By David Bogoslaw

Even after a two-month stock market rally, market volatility remains high. Simply put, investors are worried, not only over the timing of an economic recovery, but also by the possibility that the recent surge in equities may be little more than another bear market rally. The uncertainty bodes well for the popularity of low-cost exchange-traded funds (ETFs) that allow investors to jump into and out of positions with great agility throughout the trading day.

Total ETF assets increased by $49 billion, or 10.2%, for the month, to $531 billion at the end of April, according to State Street Global Advisors' (STT) April ETF Snapshot report. Since 2002, assets have increased more than fivefold, as the number of ETFs has grown more than eightfold.

The ongoing net flows of money out of open-end mutual funds and into ETFs is mainly the result of the drop in the stock market in the last few months of 2008 which "freed up the tax handcuffs" among investors, says Noel Archard, managing director for product research and development at iShares. Archard points out that investors stood to incur a much smaller tax bill, if any, from pulling money out of conventional mutual funds after the market downdraft. The poor performance by many mutual funds, coupled with the capital gains distributions they had to pay out, only added to investors' eagerness to shift into tax-efficient ETFs, he adds. He estimates that roughly $170 billion in assets migrated from mutual funds to ETFs last year.

Barclays Isn't Leaving Completely

There's been no shortage of headlines around ETFs lately, from Barclays' announced $4.4 billion sale of its prized iShares franchise to private investors, to the debut of what's being billed as the first truly actively managed ETF by Grail Advisors, a division of merchant bank Grail Partners in San Francisco. But at least some financial advisers who invest heavily, and in some cases exclusively, in ETFs, believe these developments are far less significant than all the press coverage would suggest.

There's little chance that iShares' new owner will raise expense ratios, as some people fear, in view of the competitive pressure from the other two big ETF providers, Vanguard and State Street Global Advisors, says Scott Kubie, chief investment strategist at CLS Investments in Omaha, Neb. He believes the sale is motivated more by Barclays' need of capital to shore up its balance sheet and its preference not to take money from the British government than anything else.

Indeed, Barclays will still have a presence. The way the deal is structured, with Barclays retaining a major debt stake in iShares, seems to allow for it to be bought back in a few years' time, says Richard Ferri, CEO of Portfolio Solutions in Troy, Mich.

Lots of Interest in the Grail ETF

The Grail ETF has attracted attention, but the new offering may find it hard to gain wide acceptance since to date actively managed ETFs have found it very difficult to attract assets, with no track record and no big-name portfolio manager behind the product.

Ferri, who is also the author of The ETF Book: All You Need to Know About Exchange-Traded Funds, regards the various actively managed ETFs introduced by smaller players more as experiments than serious marketing efforts. For these ETFs to really take off, a big, retail-oriented mutual fund company like Pimco needs to launch one headed by a big brand-name manager who's committed to using that strategy exclusively in an ETF format, he says.

The main reason that's not likely to happen is big-name mutual fund managers wouldn't want to cannibalize their own business. Fund managers also want to get the broadest possible distribution for a new fund and that's not possible without access to the 401(k) market. The problem is there's no brokerage platform within a 401(k) that allows for trading throughout day since the plan managers do all their trading at the end of the day, says Ferri.

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