Growth of ETFs raises concerns for investors
Growth of ETFs raises concerns for investors
Exchange-traded funds, which act like mutual funds that follow indexes and trade like individual stocks, are becoming a more common choice for investors. In a MarketWatch commentary, John Spence explores whether ETFs are the best choice for investors. "I suspect that too many ETFs will prove, if not suicidal to their owners in financial terms, at least wealth-depleting," said Vanguard Group founder John Bogle.
On the long-running television drama "Law & Order," fictional district attorney Jack McCoy's persuasive arguments often win over an undecided jury and seal the fate of that episode's villain du jour.
Now, the actor who plays the hard-driving lawyer, Sam Waterston, is making a case for exchange-traded funds in TV ads for online broker TD Ameritrade Holding Corp.
The commercials featuring the recognizable actor are another sign that ETFs -- essentially mutual funds that follow indexes and trade like individual stocks -- are moving into the mainstream.
Still, like a signature Jack McCoy cross-examination, the ads raise tough questions. Do many investors really know what ETFs are? Should you buy ETFs?
There were 603 ETFs with over $550 billion in assets and $75 billion in daily trading volume as of Nov. 12, according to Morgan Stanley. In recent years, the number and assets of ETFs have grown exponentially with more players entering the business and the investment products mirroring ever-complex strategies.
On the other hand, ETFs still represent a relative drop in the bucket for the $12 trillion mutual-fund business, although that could change if long-awaited actively managed ETFs become a reality.
This column champions the low costs, tax efficiency, transparency, diversification and trading ease of ETFs. However, it has steadily cautioned investors since its beginning to research and dig below the surface of more exotic ETFs before committing money. This closing column of 2007 looks back at what was another year of meaningful growth for ETFs and peers ahead at what could be the top storylines for 2008.
ETFs and investors: Shotgun wedding?
With truly actively managed ETFs possibly on the cusp and existing offerings now covering obscure corners of the market, it's even more important for investors to do their homework.
With truly actively managed ETFs possibly on the cusp and existing offerings now covering obscure corners of the market, it's even more important for investors to do their homework.
The ETF revolution has empowered small investors to use strategies once reserved for large institutions. Like individual stocks, ETFs can be shorted or bought on margin, for example. Yet considering the bleak track record of individual investors trying to time the market, such flexibility is questionable.
For example, Vanguard Group founder and index-fund champion John Bogle has decried narrowly focused ETFs and the temptation to trade, even as Vanguard continues to build out its own lineup of ETFs.
"I can't help likening the ETF -- a cleverly designed financial instrument -- to the to the renowned Purdey shotgun, supposedly the world's best. It's great for big-game hunting in Africa. But it's also excellent for suicide," Bogle said in a 2006 speech. "I suspect that too many ETFs will prove, if not suicidal to their owners in financial terms, at least wealth-depleting."
When the first big wave of ETF development hit the market in the 1990s and early 2000s, they were seen simply as index funds in another wrapper. But in recent years, the benchmarks tracked by ETFs have become more sophisticated, and it could be argued they have at least elements of active management embedded in them.
The business has also expanded beyond offering exposure to just stocks, to cover bonds, currencies, commodities and other asset classes. And in a bid to capture the "holy grail" of ETFs, some firms have filed products that follow pure active approaches, although they face disclosure and regulatory barriers.
Winners and losers in 2007
ETFs tracking emerging markets, steel and energy were among the top-performing funds this year. Energy Select Sector SPDR (XLE) , for example, soared 38.6% in the year through Dec. 28, according to investment researcher Morningstar Inc. Meanwhile, iShares MSCI Emerging Markets Index (EEM) gained 34.7%.
Conversely, those investing in home builders, financials and real-estate stocks were hammered by the credit crunch and subprime-mortgage concerns. Financial Select Sector SPDR (XLFS) reflected this slump, losing 19.2%
ETFs tracking emerging markets, steel and energy were among the top-performing funds this year. Energy Select Sector SPDR (XLE) , for example, soared 38.6% in the year through Dec. 28, according to investment researcher Morningstar Inc. Meanwhile, iShares MSCI Emerging Markets Index (EEM) gained 34.7%.
Conversely, those investing in home builders, financials and real-estate stocks were hammered by the credit crunch and subprime-mortgage concerns. Financial Select Sector SPDR (XLFS) reflected this slump, losing 19.2%
In terms of new-product launches, this time last year it seemed that 2007 would yield an even bigger crop of ETF listings than 2006, when more than 150 ETFs were issued. See archived story.
Indeed, as of mid-November, about 230 new ETFs had been launched, and there is still a glut of product filings at the Securities and Exchange Commission.
Here are some of the ETF stories you'll likely read more about in the coming year:
- The first active ETFs have been filed with regulators and if approved could pose a threat to traditional mutual funds.
- More ETFs are hitting the market that give investors leveraged and inverse exposure to global markets. Inverse funds, which provide the opposite return of an index, allow investors to bet against sectors or hedge. Yet these leveraged funds can magnify losses as well as gains.
- The tax benefits of exchange-traded notes, or ETNs, are in question. The IRS has already taken away the advantages of currency ETNs, and those linked to stocks and commodities may be next.
- "Lifecycle" ETFs, like those promoted by TD Ameritrade spokesman Waterston, and other offerings are trying to crack the lucrative 401(k) retirement-plan market. See earlier article.
- Money managers continue to break up the municipal-bond market with ETFs. Click here for background.
- Exchanges attempt to attract more ETF listings and volume with specialized trading platforms.
- Backers of ETFs that practice "fundamental indexing" or other variations of traditional index investing will continue to butt heads with the purists.
- ETF providers will continue to push new boundaries with more funds tracking bonds, international small-cap stocks and commodities, for example.
- Will more big money managers throw their hat into ETFs? Northern Trust Corp. (NTRS) is one with ETFs in registration.
- Will WisdomTree Investments Inc. (WSDT) be sold this year in a rich payday for the upstart ETF firm's founders? Says Chief Executive Jonathan Steinberg: "We want to be the Vanguard [Group] of fundamental indexing."
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posted by Victor Lloyd Smith @ 1:55 PM
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