Over the past 19 years, exchange-traded funds have become a favorite investment product of advisors. ETF assets stand at just over $1 trillion in the U.S. alone, according to research firm Morningstar. That's a 7,000 percent increase from 1998, when Morningstar started tracking ETF data and assets stood at $13.7 billion. In that same time period, open-end mutual funds grew from $3.7 trillion to $8 trillion, a 116 percent increase.
While ETFs are more popular than ever, they are not without risk. The bulk of ETFs may seem benign, but a rising number of innovative exchange-traded products could lead to potential problems-particularly if institutional interest in ETFs as trading vehicles continues to grow.
New & Improved Index Fund
ETFs began as a low-cost alternative to the mutual fund, a sort of improved index fund. Nathan Most, an executive at the American Stock Exchange, developed the first SPDR-Standard & Poor's depositary receipt in 1993.
After a rocky start, the new product took off and assets began growing significantly, regardless of the state of the larger market. According to a report last year from McKinsey, assets in ETPs grew 30% a year from 2000 to 2010. (ETP is a broader category, including exchange-traded commodities and exchange-traded notes, but it is still a testament to the popularity of the structure of these products.)
This growth rate was faster than any other segment of U.S. assets. "In fact, in the last decade, no other segment of the U.S. asset management industry has grown as quickly and consistently as ETFs- not managed accounts, IRAs or even the booming defined-contribution market," according to the McKinsey report.
Many advisors now use the funds just as Most had imagined 20 years ago, as a kind of better mousetrap for index investors.
Ken Wren Jr., a Raymond James financial advisor and CEO of Towne Investment Group of Towne Bank in Suffolk, Va., often uses ETFs as a low-cost vehicle for a portfolio core. "We're not 100% ETF, but there are a lot of situations where we find that it makes a lot of sense," Wren says. (Editor's Note: Wren has appeared on our "Top 20 Program Managers" list for the past two years.)
In particular, Wren sees ETFs as being more tax efficient than mutual funds in that they are less likely to be faced with unexpected capital gains distributions. And he says that the exact contents of the investment are known, unlike mutual funds.
That simplicity makes the advisors' job easier. "For the most part, they're simple to understand," says Amy Charles, a Tampa, Fla.-based senior vice president at Raymond James and director of closed-end fund and exchange-traded product research.
"You read the mandate, boom, that's the mandate. You don't have to understand that portfolio manager's philosophy."
Wren also likes the way that ETFs make it possible to gain exposure to a market that would otherwise be difficult to reach.
Commodities, foreign stocks, particular industry sectors-all kinds of possibilities are available with ETFs that would have been more difficult for individual investors to reach in other ways, he says.
Right Product, Right Time
Until now, the ETF has been the right product at the right time. As more financial advisors have moved from a commission structure to a fee-based or percentage-of-assets model, low-cost funds have become more attractive. "That has really benefited ETFs, which generally have not been structured with trailing commissions and high expense ratios and so forth," says Joel Dickson, a senior investment strategist and a principal in Vanguard's Investment Strategy Group in Malvern, Pa.
In particular, the absence of 12b-1 fees, which can range as high as 75 basis points in mutual funds and cover things like distribution and marketing expenses, has contributed to ETFs' generally good press.
The fact that the product began primarily as a new way to package indexes also has helped to keep costs down and has helped to give three large-scale players-iShares, now owned by BlackRock; State Street Global Advisors; and Vanguard-a near lock on the market. These three providers control 83% of the U.S. market, according to Cerulli Associates estimates.
ETF fees are on average just 55 basis points a year. Some are even less: Vanguard trumpets a 17 basis point cost, substantially lower than the average actively managed equity fund, which stands at roughly 79 basis points, according to the Investment Company Institute, an industry trade group.
When it comes to marketing ETFs to the bank channel, the largest players don't have to do much to reach the advisory market, according to Chip Roame, managing partner of Tiburon Strategic Advisors in Tiburon, Calif. "Little pitch is needed," he says. "These buyers know the brands, they demand very low expenses. The dollars flow where one expects."
Nor do new players have a hard time making themselves known. To reach market timers and more active financial advisors, "getting one's product offering in front of their eyes is key," Roame says. The barrier to entry is not especially high, in Roame's view. "These financial advisors have longstanding relationships buying other niche products..so they are open to the next pitch," he says.
Whether the new kids on the block succeed is another story. About 600 new exchange-traded products are now being registered, according to Raymond James' Charles, and if history is any guide, perhaps their developers should be more cautious. As many as three-quarters of all new ETFs fail, according to the report from McKinsey.
Despite those failures and the fact that more than 1,000 ETFs are now fighting for shelf space, Vanguard's Dickson doesn't believe this is the end for ETF product development. "I think there's a lot more product development that we're going to see," he says, likening the situation to that of conventional mutual funds 25 years ago.
Indeed, some pundits have even speculated that the ETF will eventually outpace the traditional mutual fund, but Dickson won't go that far. "The 800-pound gorilla is still towering over the little chipmunk in some respects," Dickson says.
Even now, ETFs make up less than 10% of the fund universe. Worldwide, mutual funds (including ETFs) hold $23.8 trillion in assets in more than 7,600 funds, according to the Investment Company Institute's 2012 Factbook.
Charles agrees that ETFs will never completely replace mutual funds. One limitation, in Charles' view, is the transparency of the holdings. Although this is generally a selling point, she argues that the fact a fund must disclose its composition every day rather than four times a year will put off many active managers.
This was not a problem this past spring for PIMCO, however, which launched its actively managed total return fund (BOND), without any apparent worry that someone might replicate its strategy. It already has more than $1 billion in assets.
It's All About Perspective
The future for ETFs could look very bright-or dark-depending on your perspective.
On the bright side, individual investors are positive about ETFs. An August 2011 Charles Schwab study of investors with more than $25,000 in investable assets found that 44% of them intended to increase their ETF holdings in the next year.
In addition, according to the ICI, current ETF holders tend to be exactly the kinds of investors that most financial advisors want as clients.
The latest ICI figures show that the average household income of ETF owners is $125,000 a year, significantly higher than $48,800 for "all households." Moreover, household investable assets of ETF owners stand at $500,000, far higher than the national average of $75,000 for all households.
Also, 73% of ETF owners have a defined contribution retirement plan; 51% of non-ETF owners have a defined contribution plan.
Plus, despite the growth they've already experienced, ETFs have a lot of room to expand even more, industry experts say.
"A lot of the major U.S. indexes are being tracked, but that doesn't mean there still aren't opportunities for other asset classes," says Alec Papazian, senior analyst at Cerulli Associates.
One of the biggest opportunities: ETFs are not used much in 401(k) and other nontaxable accounts that make up a large percentage of individual investor assets. That's at least partly because there is no good way yet for investors to buy fractional shares. "If that market can be tapped, that's a whole other set of assets," Papazian says.
And that may be coming soon. Papazian says that at least one firm is already experimenting with a process that might work around this obstacle.
Fixed-income funds, too, are still underrepresented in the market. Money market funds, in particular, are seen as an opportunity, McKinsey notes.
Overall, the biggest players in the market, which McKinsey describes as "vanilla beta" providers, are expected to continue to grow. "Vanilla beta providers with the best distribution engines will be rewarded with a self-reinforcing cycle of virtuous growth: more assets, greater scale, lower costs, lower prices, more assets," according to McKinsey's report.
Smaller players may have a tougher time, says Vanguard's Dickson. "The competitive forces will start further differentiating between those that can survive and those that just won't," Dickson says. "We probably will see a lot of consolidation in terms of a number of products that are not viable on their own."
No good product goes unpunished in the investment world. And ETFs may be no exception.
One of the grand old men of investing, John Bogle, the founder of Vanguard, often warns about the dangers he sees in the ETF market, even though ETFs have been a tremendous source of growth for Vanguard.
After pioneering the concept of passive index investing and holding investments for the long-term, he often bristles at the idea that ETFs can be traded so easily. In short, he says that facilitates speculation and ultimately hurts investors.
He told CNBC last September that people have "mixed up" two very different terms, "the wisdom of long-term investing and the folly of short term speculation." He adamantly maintained, as he has in the past, that the only way for investors to see long-term gains is to use index funds and employ a buy-and-hold strategy.
Pauline Shum, a professor of finance at York University in Toronto, agrees that ETFs can hurt investors when not used correctly.
The ease of trading tends to gives "retail investors the illusion that they have control," she says.
Since 2008, many investors have pulled out of actively managed funds and replaced them with ETFs. There is no problem with that unless they start using these vehicles for sector timing, which most studies suggest is a losing game for most investors, she says.
Of more concern still for the individual investor are leveraged ETFs, specialized funds based on options that double or triple the performance of an index if it is going up-or if it is going down.
Leveraged ETFs are a more convenient trading vehicle for leveraging an investment than having to take out margin loans and then buying the stock, Shum says, but the downside is that it can be a dangerous tool to buy and hold.
Because of the effects of daily compounding, she says, an investor who holds a leveraged fund for a month in what is ultimately a flat market can still lose money at the end of the month.
Can't We All Get Along
One quality that Dickson likes about ETFs "is that a number of different types of investors can use the product and really peacefully coexist with each other."
This is a contrast to traditional mutual funds, he says, where long-term owners subsidize short-term traders by paying capital gains distributions. ETFs don't have taxable internal trades. "All the investors are paying their own way in terms of transaction costs," he says.
But the growing popularity of ETFs with institutional investors may create risks for small investors. Institutional investors now hold a majority of ETF assets, 53%, according to a recent research note issued by Deutsche Bank.
When those positions are concentrated, small fry can suffer. Moody's Investors Service has warned that massive transactions by institutional investors could lead to exceptional volatility in certain ETFs.
It cited a single transaction on May 12, when an institutional investor suddenly redeemed 19.7 million shares ($780 million) of State Street's SPDR Barclays Capital High Yield Bond ETF (JNK) for the underlying bonds. Moody's argued that this episode was a credit-negative event for large ETF providers, because retail investors and advisors might be deterred from holding ETFs, and regulators may give the product a higher degree of scrutiny.
Another major redemption of 14 million shares made shortly thereafter left the fund selling at a 1.27% discount to its net asset value, compared with the 40 basis point premium where it had sold all year, according to Moody's.
But even such a massive trade may not be necessary to upset net asset values. In April, Birinyi Associates released a list of 24 ETFs that were trading at least 5% above or below their net asset value.
The extremes on the list included the iPath Dow Jones- UBS natural gas ETF (GAZ), which was 81% above its net asset value, and the Elements CS Global Warming exchange-traded note (GWO), which foundered 13.77% below its NAV.
Allergic to Synthetics
The Financial Services Authority in Britain has warned that the complexity of ETFs may be creating new risks for investors. In 2011, the FSA wrote in its annual note on retail investment that "consumers do not understand the difference between product types in terms of investment strategy, tax status and risk. For example, there are an increasing number of synthetic (also called swap-based) ETF products that expose investors to collateral and counterparty risk."
Such derivative ETFs are relatively rare in the U.S. but not in Europe. A recent SPDR report estimated that 60% of all European issues and 44% of European ETF assets are synthetic ETFs.
Synthetic funds don't actually hold the underlying physical asset, but instead hold a derivative-a promise to pay that mimics the performance of the physical asset. "Market exposure is obtained by entering into a swap transaction with a counterparty who agrees to pay to the fund the return generated by the assets tracked by the fund," according to the FSA report. "This introduces counterparty risk for the end customer."
The FSA isn't alone in its concern. Moody's has also warned that the growth of synthetic ETFs, particularly in Europe, may create some serious counterparty risks-potentially the same kind of structural problem, if not the same size problem, that led to the subprime disaster in 2008.
Future of ETFs
Modern financial history is filled with products that began as one thing and eventually evolve into something quite different. Futures were mostly a good way to protect buyers and sellers of agricultural products; the hedge fund was initially designed mostly to limit downside risk; and the mutual fund, which began as a simple, professionally managed portfolio of stocks, eventually grew into a vast umbrella for all kinds of investments and investment strategies.
For the ETF, too, the possibilities seem likely to reach far beyond Most's original concept of a leaner index fund.
Indeed, some ETFs are among the most heavily traded securities in the world and subject to wild shifts in popularity. In August 2011, for example, interest in ETFs soared as investors sought to take advantage of market volatility. Total dollar volume passed $2.9 trillion-one-third of that was in the SPDR S&P 500 (SPY).
Moreover, many retail investment advisors are finding that it's one of the cheapest, most transparent products they have used.
Vanguard's Dickson, for one, argues that unlike mutual funds, the fact that the underlying assets aren't bought or sold means that long-term investors aren't subsidizing short-term traders.
But given some of the risks and the warnings about synthetic ETFs-not to mention the track record of financial innovation generally-advisors may be well advised to keep an eye on how this product continues to evolve.