An increasing number of professional and small investors now see traditional… (Christopher Serra, For…)
In the early 1990s, executives of the now-defunct American Stock Exchange hatched a revolutionary idea: a hybrid mutual fund-type investment that would trade like a stock.
But in an era when hot-handed mutual fund managers had rock-star status, the concept of the “exchange-traded fund,” or ETF — low-cost, pre-programmed portfolios designed to simply replicate a broad or narrow swath of the market — didn't get a lot of people's hearts pounding.
Twenty years later, however, exchange-traded funds have ballooned into a $1.4-trillion industry in the U.S. and $2 trillion worldwide. Asset growth has surged since 2007 as the number of ETFs has soared past 1,400, covering every corner of stock, bond and commodity markets.
And although conventional U.S. mutual funds still hold more than seven times the assets of ETFs, an increasing number of professional and small investors now see traditional funds as lumbering dinosaurs, doomed to be outmaneuvered and eventually overcome by more efficient and focused ETFs.
“I don't see any justification for traditional mutual funds” to go on, said David Kotok, who manages $2.2 billion at Cumberland Advisors in Sarasota, Fla. He has been using ETFs exclusively to build client portfolios since 2000.
Don Gimpel, an 84-year-old investor in Beverly Hills, estimates that his portfolio now is 70% in conventional mutual funds and 30% in ETFs. But as he looks for new areas of investment, he sees ETFs as “the wave of the future. You can center your whole portfolio around them.”
Extinction, if it happens, won't come quickly for traditional funds. They still dominate in key markets, including 401(k) retirement plans.
But ETFs' ascent is a warning to owners of traditional funds to be vigilant: If other investors are leaving your fund for ETFs or other alternative investments, the drain could cost you dearly by forcing the fund to raise cash by dumping assets.
ETFs have blossomed as investors have responded to the funds' advantages over traditional mutual funds and other portfolio options.
Most ETFs are passive investments, meaning they are designed to replicate returns of specific market slices — say, U.S. mid-size stocks, blue-chip drug stocks, gold bullion or the Turkish stock market.
The ETF boom has provided investors with a vast menu of options to diversify their portfolios using the funds as building blocks. ETFs “give you more of a sense of control” than conventional funds, said Chris Binkley, a 38-year-old Harrisburg, Pa., investor.
Unlike mutual funds, which must be purchased directly from fund companies, ETFs trade on stock exchanges. That means they can be bought and sold any minute of the day. Most conventional funds, by contrast, can be bought or sold only once a day, at the fund's closing price for that day.
Most ETFs also offer the crucial advantage of very low portfolio management expenses, a byproduct of how they are constructed. Some take as little as 0.04% of assets a year to cover expenses, compared with the 1% to 2% that many conventional funds take.
Less for Wall Street means more for investors. Over time, the savings can be gigantic.
Although investors must pay standard brokerage commissions to buy or sell ETFs, online trades at discount brokerages typically cost less than $10. And some brokerages have been waiving all commissions, part of an ETF price war that has raged in recent months among fund titans, including BlackRock Inc., Vanguard Group Inc., Charles Schwab Corp. and Fidelity Investments.
But what has driven much of the boom in ETFs is the same basic attraction that has boosted their cousins, “index” mutual funds: ETF investors choose to own a broad swath of the market, or a specific piece of it, and accept whatever return it generates — instead of taking a chance on a fund manager to beat the market returns via savvy stock-picking.
Binkley has accumulated a portfolio that includes a number of conventional mutual funds. But in the case of U.S. large-capitalization stocks and mid-size shares, “I don't use mutual funds anymore,” he said. “Finding a manager who's going to beat the [market] index is really hard.”
Indeed, the last five years have been dismal for so-called active fund managers in the U.S. stock market's core sectors.
Just 25% of managers of large-capitalization (i.e., blue-chip) stock funds beat the benchmark Standard & Poor's 500 index in the five years through 2012, S&P Dow Jones data show.
Managers of funds that own mid-size shares fared even worse: Just 10% beat the return on the S&P 400 mid-cap index in the five years.
Binkley said he now uses the Vanguard Mid-Cap ETF (ticker symbol VO) as a core long-term portfolio holding. The fund's annual expenses amount to 0.10% of assets, cheaper than the 0.24% standard fee of Vanguard's conventional Mid-Cap Index fund.