Sign up today and take advantage of member-only content — the kind of timely, cutting edge industry insight that only Money Management Executive can deliver.
  • Exclusive Online Only Content
  • Free Daily Email News Alerts
  • Asset Management Blogs

Exchange Funds May Grow at Indexes' Expense

Over the past year there has been a lot of talk about exchange-traded funds. Industry conferences have been held on the subject, the media has written widely about them and analysts have researched them. But, are they really worth all of the attention? Do they really pose a threat to mutual funds? After all, total exchange-traded fund assets are equivalent to less than one percent of total U.S. mutual fund assets.

Exchange-traded fund assets, however, are growing rapidly, more than quadrupling in the past two years to $65.6 billion at the end of 2000, according to the Investment Company Institute of Washington, D.C. And that number does not take into account Holding Company Depository Receipts, the exchange-traded funds sponsored by Merrill Lynch of New York, since the ICI only includes exchange-traded funds that are issued by registered investment companies. With HOLDRS included, total year-end assets for exchange-traded funds was about $70.8 billion, according to Lipper of Summit, N.J. Although that is equivalent to only about one percent of total mutual fund assets, it is equivalent to more than 20 percent of assets in index funds, which totaled $332 billion at the end of 2000, according to Lipper.

There is disagreement within the industry as to where the exchange-traded funds assets are coming from and if they threaten mutual funds, and more specifically, index funds.

"It's really impossible to say where they're coming from," said Scott Cooley, a senior analyst at Morningstar of Chicago. "We're all really just guessing."

But guessing they are. The ICI contends that exchange-traded funds have not taken anything away from mutual funds, pointing to the record set for flows into stock funds in 2000. But exchange-traded funds most closely resemble index funds, and while net flows into exchange-traded funds rose from $7.2 billion in 1999 to $35 billion in 2000, flows into index funds fell from $61.5 to $26.5 over the same period, according to Lipper. While much of the decline in index funds can be attributed to the fact that the biggest component of index fund performance comes from the S&P 500 funds and large-cap growth funds have been out of favor, exchange-traded funds are absolutely an index fund competitor, according to Donald Cassidy, senior analyst at Lipper.

"Clearly, they're an alternative [to index funds]," said Cassidy. "Why would Vanguard be creating the VIPER class? Because they have a whole bunch of shareholders that, no matter what they do, they can't talk them out of trying to short-term trade their fund and so they're going to drop them into the VIPER class and let them trade on the [American Stock Exchange].

"If you go down the list of things you can do with these, they're pretty attractive - trade anytime during the day, limit and stop orders. You can trade them like stocks and yet they act like mutual funds and they have even lower expense ratios [than index funds]."

"The Cubes, [the Bank of New York's Nasdaq-100 Index Trading Stock] is just a low-cost way of getting a tech mutual fund," said Cooley. "I think mutual funds have to consider them a serious challenge."

The ICI disagrees. Both Terry Glenn and Matthew Fink, chairman and president of the ICI, respectively, said that exchange-traded funds are not a threat to mutual funds earlier this month. Exchange-traded fund assets are taking money away from individual stocks, not mutual funds, according to Brian Reid, an economist with the ICI. That notion is supported by the fact that some exchange-traded fund growth can be attributed to institutions which are using the products to perform arbitrage on any price/net asset value disparity, according to Cooley.

"Yes, there is some substitution for individual stocks, particularly in the focused [exchange-traded funds], the HOLDRs or the various iShares that deal with specific industry sectors," said Cassidy. "There's significant tradeoff there because you get rid of single stock selection risk."

But individual stock substitution is only part of the picture, said Cassidy. One can not ignore the impact of exchange-traded funds on index funds because "the numbers are too compelling," he said.

Cooley, at least from the investor standpoint, agrees.

"If I had a huge lump sum of money, I have to tell you that I'd seriously consider buying an ETF instead of an open-end index fund," he said.