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Portfolio > ETFs

Is the Day of the ETF Upon Us?

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Are ETFs on the verge of overtaking mutual funds as the middle-class, middle-American investment of choice? On the face of it, the answer is no: The mutual fund market commands about $10 trillion in assets right now, whereas the amount of assets in exchange-traded funds is closing in on just $1.4 trillion.

But all the momentum is on the side of the ETFs. One of the biggest market stories of the year is how much money has been flowing out of U.S. equity mutual funds. For the week ended August 22, domestic stock funds lost another $4.48 billion in assets, bringing the year-to-date total of outflows for these funds to a whopping $75 billion. While equity mutual funds were losing $200 billion in net outflows over the three years from 2009 to 2011, U.S. equity ETFs were taking in a total of $85 billion in net inflows. Overall, U.S. ETFs have been adding about $118 billion per year.

Yes, the trends are all in favor of ETFs. They have been adding about 2 percent in assets per month lately, according to a study from State Street Global Advisors.  There are more than 1,400 ETFs now being actively traded on U.S. markets, up from 350 funds in 2006. At the end of 2000, there was just $59 billion invested in ETFs, according to Morningstar data, which means that in little more than a decade, their assets have grown by 200,000 percent.

But even more than the raw numbers, the way in which ETFs have come to be used suggests that they are here for the long haul, and have a lot of growth left within them. ETFs have sometimes had the reputation of being for short-term traders, as opposed to mutual funds, which more often fall into the buy-and-hold category. But a new study from Vanguard has shed a little different light on that.

The majority of Vanguard customers’ trades in ETFs — 62 percent of them — were the result of strategic allocation decisions and were expected to be held for more than a year That’s less than the 83 percent of all mutual funds trades that fell into the same category, but it’s in the same ballpark.

Vanguard looked at what it calls “investment reversals” — the first buy after a sell or the first sell after a buy — for both mutual funds and ETFs, and found that they were very similar over the long term. About 95 percent of all ETF investments averaged fewer than four investment reversals per year, as opposed to 99 percent for mutual funds.

Moreover, Vanguard found that much of the difference in strategies between the two vehicles can be attributed to the fact that investors in ETFs tend to be heavier traders than those who buy mutual funds. Once the study controlled for previous behavior, it turned out that ETFs were used in buy-and-hold strategies nearly as much as mutual funds were.

“Our evidence suggests that we’re not seeing ETFs cause people to trade more frequently,” said the senior investment strategist for Vanguard, Joel Dickson, upon the release of the study. “Rather, what we’re finding is that people who trade more are choosing ETFs more frequently these days.”

ETFs have been invading the institutional space as well. From their beginnings, they were seen as the province of the little guy and the individual trader, but now institutional investors control 53 percent of the ETF assets out there, according to a study from Dow Jones Newswires. Financial advisors controlled 25 percent of the ETF market, while brokers controlled 20 percent.

And while equity mutual funds have been having a horrible time of it, equities remain the backbone of ETF investing. In the ETF universe, stocks account for 69 percent of all assets, while fixed-income instruments account for just 19 percent.

At the same time, ETFs still retain their roots as the province of frequent traders. Vanguard found that State Street’s widely held SPDR S$P 500 ETF — the most popular such fund containing nearly 10 percent of all ETF assets — has a turnover ratio of greater than 30 percent a day. That suggests that the average holding period for SPDRs is just three days.

Here’s another fact that is indicative of the mindset of the average ETF investor: About 16 percent of all people who are invested in Vanguard’s mutual funds log on to every day. But more than twice as many — 36 percent — of Vanguard’s ETF clients log on to the site daily.

So ETFs remain the vehicle of choice for the nervous, frequent trader. Their liquidity and transparency will likely make them popular with that sort of investor for a long time. But they are heading for the mainstream as well, and in the coming years, even the most conservative buy-and-hold investors could end up making ETFs a significant part of their portfolio.

For more from Tom Nawrocki, see:

Prospects in Gold

Apple in the Dow

America’s 10 Biggest IPOs


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