Are exchange-traded funds (ETFs) beginning to show their warts? ETFs are still receiving lots of fanfare despite the fact that ETFs, not mutual funds, felt the biggest brunt of the "flash crash" on May 6. The Wall Street Journal reported after the flash crash—in which the Dow fell 1,000 points in a matter of minutes—that 68% of the trades that were cancelled involved ETFs.
While the most recent data from the Investment Company Institute (ICI) shows that money continues to pour into ETFs—combined assets of the nation's ETFs jumped 10% to $882.75 billion in September 2010—assets in ETFs are still dwarfed by assets held in mutual funds, which ICI says increased in September by $486.2 billion to a little more than $11 trillion.
There's no doubt that "ETFs currently have a halo effect around them that traditional open-end mutual funds have lost," Don Phillips, president of fund research at Morningstar, told me in a recent interview. While it's true that mutual funds "have a lot more baggage right now than ETFs," the "bad things associated with ETF investing, to date, are not really sticking," Phillips adds. "It will be interesting to see how long this honeymoon period lasts for ETFs."
I spoke with Phillips and other ETF experts like Jim Lowell, editor of Fidelity Investor, and Daniel Wiener, editor of The Independent Adviser for Vanguard Investors, to get a sense of where the ETF market stands now and where it's headed. I also got feedback from advisors themselves on how—and why—they're using ETFs.
Saturation Point for ETFs
Lowell, who's also a partner and chief investment strategist with Adviser Investments, a private money management firm advising more than $1 billion based in Newton, Mass., says that the "belief system" created over the last three to five years that ETFs are the best investment vehicle because their asset growth was so spectacular is beginning to break down. The reason: the performance of active managers over the last 18 months. "ETFs and active managers behaved almost identically in the 2008 to March 2009 [economic] meltdown," Lowell says, "but then active managers just surged coming out of the trough, the way you would expect them to do, whereas ETFs just gave benchmark returns, which were also good, but they weren't 70%-plus returns."
The momentum behind ETFs is "certainly not as robust as it was, even a year ago," Lowell says, adding that ETFs may have hit a saturation point inside the advisor marketplace, at least for the time being. Approximately 10% of Adviser Investments' assets are in ETFs, Lowell points out, and he says it's hard to make the case for adding "demonstrably more."
Wiener, Lowell's colleague and chairman of Adviser Investments, adds that the bulk of their clients are still using actively managed mutual funds "because we buy managers—we look for the best managers out there." He adds: "It is true that the average active manager underperforms the index, but it is not true that a portfolio focused on really excellent managers underperforms the market—in fact, it outperforms."
