Gallery:Step 8|Step 8: Riskese

ETF Industry Poised for Next Round of Growth

Gallery:Step 8|Step 8: Riskese

The exchange-traded fund universe is expanding - at last count growing to 135 ETFs trading in the U.S. with over $112 billion in assets under management. Likewise, in the coming weeks we'll be enhancing our own editorial coverage of ETFs with more frequent news stories and features on these funds.

Although ETFs have experienced tremendous growth since the mid-1990s, they certainly have not sent traditional indexed mutual funds the way of the dodo, as some pundits predicted they quickly would. For comparison's sake, retail index fund king Vanguard (which has introduced ETFs as separate share classes of its index funds) as of April 2003 had $200 billion in indexed assets under management spread over 40 index funds.

An estimated $1 trillion is indexed to the domestic equity market, mainly in private accounts for pension plans and other institutional investors. ETF assets at this point are still a drop in the bucket when compared to the mutual fund industry as a whole.

However, increasing numbers of advisors and investors are taking advantage of the unique benefits of ETFs. As a prelude to our stepped-up coverage, here we'll take a look at some of the main advantages (and also disadvantages) of ETFs, how investors and advisors use them, and what's next for ETFs. This article also contains links to several previous articles that deal with some of the more advanced topics on ETFs.

ETF Benefits

Active/passive debate

Like traditional index funds, existing ETFs attempt to track - not beat - the performance of a given benchmark, providing both diversity and low cost. Countless studies have illustrated that a majority of active fund managers fail to beat their relevant benchmarks in most equity categories over longer time periods.

Percentage of Active Open-End Fund Managers That Outperformed Benchmark (15 Years Ended 12/31/02)
 
Value
Blend
Growth
Large
10%
22%
44%
Mid
27%
45%
39%
Small
33%
42%
81%
Source: Morgan Stanley Equity Research (Russell indexes were used for comparisons - Russell 1000 series for large, Russell Midcap series for mid, and Russell 2500 for small)

Cost

A fund's expenses can have a significant impact on the returns of long-term investors, probably more so than most investors realize. To illustrate the importance of costs, we used the SEC's mutual fund cost calculator.

Imagine an investor with a long time horizon of 25 years has $10,000 to invest in a fund. Assuming a 10% average annual return (let's be optimistic) and a 1.5% expense ratio, at the end of 25 years this investor will be left with over $74,000, according to the SEC cost calculator. However, that same $10,000 invested in a fund with an expense ratio of 0.5% would grow to over $95,000, all other factors being equal.

Expenses of ETFs vs. Open-End Mutual Funds
Category
Average expense ratio
Exchange-Traded Funds
U.S. Major Market ETFs
0.18%
U.S. Style ETFs
0.23%
U.S. Sector ETFs
0.34%
All U.S. Equity ETFs
0.28%
International Equity ETFs
0.41%
All Equity ETFs
0.40%
Fixed Income ETFs
0.15%
Open-end Mutual Funds
Actively Managed Domestic Equity
1.40%
Actively Managed International Equity
1.94%
Passive/Indexed Domestic Equity
0.75%
Passive/Indexed International Equity
0.95%
Passive/Indexed Fixed Income
0.39%
Source: Morgan Stanley Equity Research

Tax efficiency

ETFs are inherently tax efficient because, like index funds, they track a benchmark and have lower turnover than active funds. However, ETF in-kind redemptions offer further tax protection from capital gains.

Tax strategies

Financial advisors use ETFs for sophisticated index fund tax-swap strategies to maintain equity exposure while offsetting realized or unrealized gains in a portfolio. The broad universe of ETFs allows investors to "swap" into similar ETFs to maximize tax efficiency and maintain market exposure while avoiding violation of the wash-sale rule.

ETF Disadvantages

As shown in the figure above, in many cases ETFs have lower expense ratios than comparable index funds. However, there's more than meets the eye. Since ETFs trade like stocks, they are subject to brokerage fees and trading spreads. Therefore, ETFs are not effective for dollar cost averaging small amounts over time, and likewise any strategy using ETFs must account for these additional costs.

However, the tax and cost advantages of ETFs become more attractive to those investors who have a significant lump sum to invest and a long time horizon.

What's Next?

The ETF industry appears poised for a new round of expansion in the coming months and years - possibly new fixed-income ETFs, options on more existing ETFs, and equity funds tracking increasingly sophisticated benchmarks.

For example, Rydex recently introduced a new fund tied to an equal-weighted S&P 500 that will automatically rebalance quarterly.

PowerShares Capital Management last month launched two ETFs that track proprietary "dynamic" equity indexes managed by the American Stock Exchange. The new funds appear to be the next step toward actively managed ETFs, although fund providers have a host of regulatory issues to deal with before such products hit the market. However, leveraged ETFs as well as inverse ETFs designed to move in the opposite direction of an index could hit the market sooner.

Finally, many industry observers are awaiting the launch of new Vanguard VIPERs ETFs once Vanguard's equity index funds complete their transition to new U.S. MSCI benchmarks.