June 19, 2000
Although exchange-traded funds will not supplant mutual funds in the near future, they will be the driving force behind industry changes in the next decade, creating opportunities for some firms and threatening others, according to a recent study.
"If a firm looks at itself as only being in the business of managing and/or distributing traditional open-end funds, and does not have a vision for expanding beyond that narrow definition, then the growth of exchange-traded funds is most definitely a threat to their franchise, as is the growth of separate accounts and other vehicles that compete with traditional funds," said the study, conducted by Financial Research Corp. of Boston.
In much the same way that index funds and supermarkets contributed to the growth and evolution of the mutual fund industry, exchange-traded funds will help the firms that offer them to address investors' changing preferences, the survey said.
For the survey, FRC conducted hundreds of interviews with investors to determine their knowledge of exchange-traded funds. FRC also used responses to questions on the topic, put to a panel of fund executives and analysts, said Steve Cummings, an analyst with FRC.
Exchange-traded funds are not a threat to actively-managed mutual funds but they may be an alternative to index and sector funds, said Dan Ross, president of Wechsler Ross & Partners of New York, a marketing and design firm that specializes in the asset management industry. Ross is also the publisher of MF Cafe, a mutual fund industry website.
Because exchange-traded products could serve investors needs as well if not better than index or sector funds, they could be used as alternatives to them, he said.
"[Exchange-traded funds] are not a passing fad," he said. "Mutual funds have been phenomenally successful because they meet some real needs, but there are vulnerabilities centering around liquidity and taxation issues," he said. "I believe that exchange-traded products will be successful in market segments where these issues are most relevant, like index funds."
Assets in exchange-traded index funds will grow to between $201 billion and $500 billion over the next five years, according to the industry executives and analysts polled for the survey. Exchange-traded index funds will grow from eight percent of all index fund assets to 27 percent, according to the survey.
Although exchange-traded funds are not a direct threat to actively-managed mutual funds, they have the potential to steal some of their prominence as investment products, Ross said. Investors may look to exchange-traded funds as novelties to replace mutual funds.
Firms that can quickly develop an exchange-traded fund will benefit from the product's novelty, according to the survey.
"Early adopters will likely benefit from a substantial first-mover' premium," the survey said. "This will come from a groundswell of free media coverage, and the opportunity to brand a firm as an innovator in a culture that seems to idolize innovation."
While existing exchange-traded funds do not pose a threat to the fund industry, actively-managed exchange-traded funds would have a dramatic impact on actively-managed funds, the survey said. Although no firm has been able to figure out how to develop an actively managed exchange-traded fund, once developed, such funds could capture as much as $58 billion in assets in their first year and between $244 to $500 billion within five years, according to the survey.
Currently, several companies are working on developing an actively- managed exchange-traded fund, according to Darlene De Remer, director of Internet advisory services for New River Investor Communications of Andover, Mass. An actively-managed exchange-traded fund could be launched within the year, she said.
Informing investors about exchange-traded funds through a concerted public relations campaign is vital to the development of the product, De Remer said.
"I think it will take a while for investors to embrace them," she said. Index funds did not really catch on with investors until five years after they had been released and they finally became popular with investors after they had been used in some 401(k) programs, she said.