Rise in ETF Use Tied to Growing Confidence

The popularity of exchange traded funds (ETFs) as an investment vehicle continues to grow, with total assets in U.S. ETFs crossing the $1 trillion mark late in 2010 for the first time. Mutual funds still attract the greatest amount of assets from advisors, around one-third of the total, according to the latest Rydex|SGI AdvisorBenchmaking report. But ETFs represent the next-highest amount, around 13%.

Much of the growth in ETFs is due to advisors using them to help clients efficiently and cost-effectively take advantage of investment opportunities around the world in the equity, fixed income and alternative investment markets. ETF asset growth is lately also benefiting from a strong corporate-profit picture and improved economic conditions in the U.S., which are supporting a broad-based rise in equity markets that has lasted for almost two years.

ETF usage may also be an outgrowth of increasing confidence among investors, consumers and advisors alike, as the damage inflicted by the financial crisis and subsequent recession continues to subside. The key index of investor sentiment was close to its 2010 high at the end of 2010, and consumers’ optimism about jobs and the economy helped lift the best-known consumer confidence measure in January to its highest level in seven months. But it is the confidence of investment advisors that is showing the most strength at the start of 2011. After jumping 4% in December from the prior month, the Advisor Confidence Index ended 2010 at its highest level in almost four years.

Encouraged by the general improvement in the economy, most advisors appear willing to use ETFs to implement at least a portion of their clients’ portfolio strategies. In the latest AdvisorBenchmaking report, for example, more than 70% of advisors say they are using ETFs in client portfolios, and about the same percentage say they are likely to increase their use of the ETFs in the future. Although ETF usage is well-entrenched in advisors’ thinking, clients may not be as clear on the benefits ETFs provide, especially when compared with mutual funds. So investor education is a critical role for advisors who favor ETFs.

According to the 2010 Rydex|SGI AdvisorBenchmarking report, the main reasons advisors use ETFs are their exposure to specific benchmarks, their transparency and their cost. The appeal of tapping into useful benchmarks is understandable, since many were not accessible to retail investors until ETFs came along. Today, the most popular ETFs usually track broad indices, but there is an ETF for most every asset class, if not every sector and sub-index. From the most remote geography to the least familiar commodity, an ETF is seemingly available.

ETFs have been especially popular in the commodities space, although more assets flow into commodity mutual funds than commodity ETFs according to a recent Lipper report. But there’s one exception—in the precious metals sector. The report said that 25 precious metals ETFs have had $8 billion in net inflows, compared with only $3.7 billion via mutual funds.

ETFs also offer transparency in holdings and operations. Advisors can often see what stocks or other instruments an ETF is holding on a daily basis, and the actions of authorized participants whose job it is to create and redeem ETF shares at any time, as market conditions warrant, help ensure that ETF market prices will closely reflect the value of their underlying holdings. Moreover, ETFs publish their calculation of an ETF’s intraday market value based on the current price of the underlying securities. The indicative intraday value, as it is known, has its own ticker and is updated and published continuously throughout the trading day.

Many advisors are drawn to ETFs for their costs and tax efficiency. The expense ratio of many ETFs is usually well below that of a similar-strategy mutual fund, and for some ETFs the cost is only a few basis points. Because ETFs trade on an exchange like a stock, investors can buy and sell ETFs without causing the fund manager to raise cash to meet redemptions, as in a mutual fund, thus avoiding a taxable event.

ETFs and mutual funds are likely to continue to be the leading vehicles where advisors put their clients’ money, and in certain circumstances, one may offer an advantage over the other.

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