More Active ETFs Expected to Grow

Even with a long-term shift to passive investing, "managed solutions" packaging exchange-traded funds should also grow rapidly, said Scott Burns, Morningstar's ETF expert.

The market plunge in 2008 was much harder to explain to investors in active-managed funds, said Burns, who directs ETF, closed-end and alternative fund research for Morningstar. As a result, many planners are switching to passive investments, especially ETFs. The move is part of an overall shift to fee-based planning practices, which, he said, involve less hand-holding.

"Even during the massive outflows in 2008, passive investments still had inflows, both in stocks and bonds," Burns told American Banker's sister publication Financial Planning. Passive investors kept investing and rebalanced their portfolios to maintain their allocations. "The big panic came with investors who had been sold on an active manager," he said. "Even if you did better than the benchmark, the investor didn't expect to ever have a losing year."

Total U.S. investments in ETFs are approaching about 10% of the entire investment in mutual funds — and are greater globally. In their first decade, from 1994 to 2004, ETFs became a favorite of institutional investors. Between 2004 and 2006, they began attracting individual investors and advisers for trading and for buy-and-hold strategies.

Today, ETFs account for 38% to 45% of the trading volume of the New York Stock Exchange, and the major players — SPDR (S&P 500), QQQ (Nasdaq 100) and EEM (iShares emerging markets) — are "more heavily traded than anything on the planet," Burns said. It's now possible to trade ETFs for free at Vanguard Group and Charles Schwab & Co., and the lower fees make it possible to use ETFs for dollar-cost-averaging approaches involving small amounts. ETFs don't carry sales loads and without a 12b-1 fee, save another 20 basis points over a mutual fund.

ETFs offer the easy diversification, low expenses and tax efficiency of index mutual funds, along with the attractions of ordinary stocks — the possibility of setting limit orders, short-selling or using options.

Although most ETFs are passive, there is a "nascent" move toward actively managed ETFs and rapid growth in "managed ETF solutions" with tactical structures that allow managers to pick up on momentum. "This will be the fastest-growing area," for ETFs, Burns said, predicting that in five to 10 years the majority of advisers offering ETFs to their clients will use a "turn-key ETF solution." The strategies are getting good results in academic literature, Burns said.

Will ETFs kill mutual fund companies? No, Burns said, because major mutual fund companies like Vanguard also provide ETFs. Some mutual fund companies that haven't gone into ETFs are T. Rowe Price and Templeton.

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