From the April 2009 issue of Wealth Manager Web • Subscribe!

April 1, 2009

The ETF Edge

Bear markets are bad for business. Portfolios decline, pinching fee income. Clients bail, putting further pressure on AUM and fees.

And raising fresh assets is, well, challenging.

That's why what happened in the exchange-traded-fund industry in 2008--the worst year for stocks in more than 70 years--is nothing short of remarkable. U.S.-based exchange-traded funds attracted roughly $180 billion in net inflows last year.

To show just how impressive that performance was, consider what happened to open-end mutual funds. It's estimated that mutual funds worldwide saw net outflows in the neighborhood of $320 billion in 2008.

Why were investors throwing money at ETFs at the same time they were fleeing mutual funds? It certainly wasn't performance. Most ETFs got hammered in 2008. In fact, most equity ETFs posted losses of 35% or more.

Zero-sum game

No, investors were not funneling funds to ETFs because they enjoy losing a third of their money. So why the love?

Take another look at that difference between inflows for ETFs and outflows for mutual funds. (You can see institutional net flows for Select Sector SPDRs in the Advanced Investing Strategies section of the redesigned WM Web site at www.wealthmanagermag.com-Ed.)

While it's impossible to prove, I have a hunch that ETFs and mutual funds--especially on the equity side--are engaged in a zero-sum game these days when it comes to inflows and outflows.

Indeed, investors and advisors who use funds as their investment of choice are finding ETFs to be a much more attractive structure than traditional mutual funds. And they are taking their money out of mutual funds and putting it into similar ETFs.

Just look at ETF inflows in October and November. I don't have to remind you just how badly stocks performed in those months. Yet, despite the horrendous performance of virtually every asset class in those two months, ETFs had net inflows of around $33 billion. Conversely, open-end mutual funds were hemorrhaging assets to the tune of nearly $170 billion.

Let's return to my zero-sum game theory for a minute. It's telling that ETFs were garnering assets not just for 2008 overall, but even during arguably one of the wildest and most volatile two-month periods in history. Indeed, four of the five largest one-day point gains in the DJIA occurred in 2008--all of them occurring in October and November. And four of the five worst one-day point declines in the Dow also occurred in 2008, with two of those days being in October.

It wasn't just daily volatility that was high; intraday volatility was off the charts. The nine largest intraday point swings in the Dow's history occurred in 2008, with eight of those days occurring in October and November. And in yet another example of intraday volatility, approximately 26% of daily trading volume in S&P 500 stocks in November took place in the last hour of trading, with 17% of the trading occurring in the final 30 minutes.

The bottom line is that the market in 2008, especially in October and November, was not just volatile on a day-to-day basis, but also hour-to-hour and even minute-to-minute.

In such a volatile market, the need for nimbleness increases. Unfortunately, open-end mutual funds don't allow you much trading flexibility. Whether you place a trade for a mutual fund at 10 a.m. or 2:30 p.m., your transaction will take place at the end of the trading day, and you will get whatever the prevailing price is at that time. In an environment when markets are flying all over the place, and you need to make decisions--perhaps you have client orders to go to all cash if a certain market threshold is breached--you simply can't get much precision with open-end mutual funds.

That's not the case with ETFs, which offer instant pricing and liquidity. And investors are taking advantage of that liquidity by trading ETFs in big numbers. For example, in October ETFs represented nearly 40% of all equity trading volume.

Tech ETFs

Clearly, in volatile markets, investors and advisors feel more comfortable with ETFs than traditional mutual funds. And with market volatility not likely to disappear anytime soon, I expect to see a continued migration of assets from mutual funds to ETFs, especially in those sectors of the market that tend to be more volatile.

Like technology.

At the end of 2008, nearly $6 billion was invested in technology ETFs. Another $12.5 billion was invested in the NASDAQ Index-100 (QQQQ), which is roughly 60% in technology stocks. I suspect you'll see those asset levels rise over time as fund investors transition from tech mutual funds to ETFs. And that transition is not driven only by the trading liquidity tech ETFs provide. Other factors are:

Lower fees--The expense ratio of the typical tech mutual fund is 1.74%. For tech ETFs, the average expense ratio is considerably lower at 0.58%.

Tax efficiency--Portfolio turnover in the typical tech mutual fund is 183%. More turnover means potentially more tax liabilities if the fund is held in a taxable account. With the ETF structure, tech ETFs should be much more tax friendly.

Transparency--Mutual funds report their holdings every three months. ETFs report their holdings daily. The transparency of ETFs makes the job of portfolio diversification much easier for both investors and advisors.

Transparency also makes it easier to make investment judgments when considering ETFs. I find it ironic that mutual funds are perhaps the only investment in which investment decisions are based on everything except what the fund actually owns. That's because you generally don't know exactly what the fund owns. As a result, funds are chosen on the basis of manager tenure, expenses or perhaps that most suspect of all selection criteria--past performance. The beauty of ETFs is that, in addition to those factors, you have one more weapon in your arsenal: You can actually evaluate the ETF's portfolio holdings almost in real time.

Taking a closer look

Put another way, ETF transparency enables you to make inferences about future performance based on evaluations of the individual holdings. Being able to look into ETFs down to the component level is invaluable for advisors who have a quantitative system they can use to evaluate the individual holdings.

My firm has such a system. Our Quadrix stock-rating system ranks upward of 4,000 stocks based on more than 100 different variables. Those variables are divided into six categories: Value, Momentum (operating momentum, such as sales and earnings growth), Earnings Estimates, Financial Strength, Performance (stock price performance) and Quality. Weightings are assigned to each metric, and scores are computed for each category. The category scores are then totaled to compute an Overall Quadrix score. Our Quadrix scores are percentile rankings; an Overall score of 90 means that a stock scores better than 90% of the 4,000 stocks in the Quadrix universe.

I'm not suggesting here that Quadrix scores, or any other ranking system, should be the sole criteria for selecting tech ETFs. Still, being able to make quantitative judgments about ETF holdings should increase your chances of separating winners from losers.

Chuck Carlson, CFA, (ccarlson@horizoninvestment.com) is CEO of Horizon Investment Services LLC and author of the book, Winning With The Dow's Losers. David Wright, CFA, provided research assistance on this article.

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