Surging
ETFs take a bite out of mutual fund flows
Growth
rate unmatched by any other product
By Frederick P. Gabriel Jr.
As if a growling bear market isn’t enough, mutual
funds have another beast breathing down their necks — exchange-traded funds.
After eight years of relative obscurity and so-so
asset growth, ETFs are suddenly causing heads to swivel in the $7 trillion
mutual fund industry. ETFs issued a net $26.8 billion of new shares during the
fourth quarter, nearly as much as the $29.6 billion that went into mutual
funds.
At the end of January, the combined assets of the
nation’s ETFs totaled $72.1 billion, a 10% increase from the level a month
earlier. That’s on top of last year’s doubling of ETF assets.
Assets in the nation’s 4,415 stock mutual funds,
meanwhile, dropped 2% in 2000 and climbed 3.3% in January, according to the
Investment Company Institute, a mutual fund trade group in Washington.
Gavin Quill, an analyst at Financial Research Corp.
in Boston, says ETFs are on track to reach $500 billion in assets by 2007,
maybe sooner. “FRC is not aware of any other major financial product category
that came close to matching the asset growth rate of exchange-traded funds in
2000,” he says.
“If S&P 500 index funds were the most notable
success story from 1996 to 1999, and technology funds were the talk of the
industry in 1998 to 1999, then their headline--grabbing successors in 2000 were
probably the index-based exchange-traded funds.”
An ETF is essentially the low-cost love child of a
stock and an index mutual fund. Like index mutual funds, ETFs invest in baskets
of stocks that mirror a particular index. But, like stocks, they are traded on
stock exchanges at prices determined by the market.
Spiders — the oldest ETFs, dating to 1993 — track the
Standard & Poor’s 500 stock index. Diamonds track the Dow Jones Industrial
Average, and Qubes follow the top 100 stocks of the Nasdaq Composite Index.
To illustrate the popularity of ETFs, about $609
billion worth of Qubes was traded in 2000. According to Lipper Inc., that
equals the combined value of trades last year in the stocks of General Electric
Co., General Motors Corp., Exxon Mobil Corp., Merck & Co. Inc., Philip
Morris Cos. Inc., DuPont, Sears Roebuck & Co. and Safeway Inc.
It took index mutual funds a little more than 24
years to reach $70 billion in assets. ETFs, however, hit that mark in just
seven years. “These things have come on quite strong, probably stronger than
most people expected,” says Don Cassidy, senior research analyst at Lipper, the
New York fund tracker.
While ETFs have yet to catch on with
do-it-yourselfers, they are popular among institutional investors, who like
them as a hedging vehicle or as a means of equitizing cash or maintaining
market exposure during periods of transition. Financial advisers also like ETFs
because they are tax efficient, easy to trade and relatively cheap.
ETFs that track domestic stock indexes come with
expense ratios between 0.09% and 0.5% of assets. By comparison, the average
indexed mutual fund and stock fund have expense ratios of 0.9% and 1.5%,
respectively, according to Lipper.
For example, sales at San Francisco’s Barclays Global
Investors, which runs $8.63 billion in 60 domestic-stock ETFs, are split evenly
between institutional investors and financial advisers, says Lee Kranefuss, CEO
of its individual investor group.
“Almost everyone has heard of ETFs,” Mr. Kranefuss
says of the adviser market. “There’s a smaller group that knows the ins and
outs and has used them. That group tends to be the more experienced managers,
the ones that are doing higher average account balances.”
Consider Michael Chasnoff, president of Advanced
Capital Strategies, an investment adviser in Cincinnati with about $200 million
under management. Late last year, Mr. Chasnoff moved about $5 million in client
assets out of a small-cap mutual fund and into an ETF in the same asset class. What
was his reason? The mutual fund, which posted a loss for the year, was about to
make a significant capital gains distribution. By switching to an ETF, he was
able harvest the losses for his clients and avoid additional income
recognition.
“We really haven’t bought many of the non-listed mutual
fund indexes in quite a while now,” says Mr. Chasnoff, who began using ETFs in
early 1999. “We really think the exchange-traded fund is the superior class of indexing.”
Ram Kolluri, president and chief investment officer
of GlobalValue Investors Inc. in Princeton, N.J., puts about one-third of his
clients’ assets into ETFs, particularly those that track the S&P 500. The
rest is in-vested in portfolios of growth stocks that he manages.
“By putting some money in ETFs as a core holding, I
get a very nice hedge,” he says. “It’s the perfect vehicle for buying and
holding for the long term.”
Last year, Mr. Kolluri’s portfolio dropped about 15%
versus a 21% drop for the S&P 500/Barra Growth Index, he says.
Despite the sudden popularity of ETFs, most mutual fund
companies aren’t worried about them — at least publicly. The No. 1. player,
Boston’s Fidelity Investments, says it has no plans to launch any ETFs of its
own. Neither does Boston-based Putnam Investments, which is ranked No. 4 in
terms of assets.
The Vanguard Group, the No. 2 fund company and a
leading seller of index mutual funds, isn’t taking any chances. By early
summer, the Malvern, Pa., company expects to launch five ETFs, to be called
Vipers. Those exchange-traded funds will be modeled after existing index funds.
“It’s a way of luring the short-term investors out of our traditional shares classes,”
says spokesman John Woerth. “It insulates our long-term shareholders from the
effects of short-term trading.”
But doesn’t it also insulate Vanguard from the
siphoning of assets from index funds into ETFs? “I wouldn’t argue with that,”
Mr. Woerth adds. Chicago’s John Nuveen Co. announced plans in October to launch
its first stock ETF and three months later said it would come out with the
first ETFs indexed to track Treasury indexes. Barclays Global Investments is
also developing fixed-income ETFs as well as making plans to launch another 20 domestic-stock
ETFs this year.
Still, ETFs are not for everyone. Those who invest a
relatively small amount of money — say $200 — each month are better off
sticking to mutual funds. That’s because, like stocks, ETFs come with
commissions that can make it expensive to get in and out.
Concentration can also be an issue. The overwhelming
majority are quite small, which raises the question of their long-term
viability. Just two groups of funds — the Spiders, managed by Boston’s State
Street Global Advisors, and the Nasdaq 100 Index Shares, run by Bank of New
York Co. Inc. — represent 62% of assets.