In dismal market, ETFs take on added allure

In the current economic maelstrom, exchange traded funds are beating mutual funds in the fight for investor dollars — a battle that will have long-term implications for the asset management industry. In September and October, investors put $61 billion more into U.S. ETFs than they took out, while a net $126.7 billion flowed out of stock and bond mutual funds, according to Barclays Global Investors of San Francisco. Even so, total ETF assets stood at about $489 billion as of Oct. 31, down from $588 billion the previous month, due largely to market depreciation, according to the National Stock Exchange Inc. of Jersey City, N.J. Total stock and bond mutual fund assets stood at $5.8 trillion as of Oct. 31, down from $6.9 trillion the previous month, according to preliminary results from Morningstar Inc. of Chicago. Obviously, ETFs have a long way to go before they catch up to mutual funds in total assets, but certain trends are moving them in that direction, according to industry experts. One is the realization by investors, spurred by the stock market's collapse, that some actively managed mutual funds aren't delivering promised alpha, which is the excess return of the fund relative to the return of the fund's benchmark, said Lee Kranefuss, global chief executive of iShares ETFs at BGI.
Many actively managed funds are either underperforming their benchmarks or have followed their benchmarks into negative territory, he said. With that, investors are coming to the realization that they're paying for beta — that is, what a fund earns simply by being in the game, Mr. Kranefuss said. That favors ETFs, which deliver beta cheaper than actively managed funds, he said. Once investors grasp this concept, it will stick, Mr. Kranefuss said. "In a down market, the active managers end up having to explain alpha and beta," he said. "Investors then say, 'Wait a second. I'm paying for beta?' It's quite a hurdle to overcome."

ALPHA VERSUS BETA

Not everyone agrees. "Personally, I think the alpha/ beta separation story is a bit exaggerated," said Benjamin Poor, a director with Cerulli Associates Inc. of Boston. "Alpha doesn't fall off the bone like baby-back ribs." Manager alpha is variable and hard to isolate, he said. "That being said, when returns fall, investors become more price-sensitive," Mr. Poor said. Talk about alpha and beta is big among institutional investors, but it's not something financial advisers spend much time on, said Mark Balasa, financial adviser and co-president of Balasa Dinverno & Foltz LLC of Itasca, Ill., which manages $1.5 billion in assets. Advisers are more likely to view ETFs as simply as tools, he said. In a down market, however, they are particularly attractive tools, offering more flexibility than mutual funds when pinpointing market segments, said Nicholas Spagnoletti, a partner at Macro Consulting Group LLC, a Parsippany, N.J., firm that oversees $300 million in assets. ETFs also offer greater flexibility to get into and out of markets because they trade like stocks and are particularly valuable when volatility is high, Mr. Kranefuss said. And because they are based on an underlying index, ETFs are more transparent than actively managed funds, Mr. Kranefuss said. Flexibility and transparency are all very well, but such attributes don't necessarily mean ETFs will continue to outstrip mutual funds when it comes to bringing in new money, said Scott Burns, director of ETF analysis at Morningstar and editor of Morningstar ETF Investor. "The reality is ETFs have been winning the past two months," he said, noting that similar big inflows occurred during the dot-com bust in 2001 and 2002. But when markets resumed their upswing, investors went back into actively managed funds, he said. Having seen the benefits, however, this time it's difficult to see investors' interest in ETFs waning, Mr. Kranefuss said.

READY TO LAUNCH

That's something ETF providers are counting on as they prepare to launch more funds. As total assets have declined during the current meltdown, ETF launches have slowed. In this year's first half, 87 ETFs were launched, compared with 167 during the same period in 2007, according to State Street Global Advisors of Boston. The first half also was marked by a spike in ETF closings. Eleven ETFs from Claymore Securities of Lisle, Ill., and five from Ameristock Corp. of Moraga, Calif., were liquidated as a result of slow asset growth, according to SSgA. But there are signs that new issuance may pick up. Last month, Barclay's launched a series of target date ETFs and two fixed-income ETFs. RevenueShares Investor Services, the firm that launched the first revenue-weighted ETFs earlier this year, unveiled its first sector fund on Nov. 12 and has plans in the works to offer other such funds. RevenueShares is a division of Pacer Financial Inc. of Paoli, Pa. There are currently more than 700 ETFs in existence and more than 500 in registration. "At this rate, it might not be that long before there are more ETFs than stocks," Mr. Kranefuss said. While investors are unlikely to see a tidal wave of new ETFs any time soon, ETF providers are pleased with the inflows into established products, said James Ross, a senior managing director at SSgA. "I think it's been a positive story for the industry," Mr. Ross said. E-mail David Hoffman at dhoffman@investmentnews.com.