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Shorting, Stop-Loss Fuel Explosive ETF Growth

In bull market and in bear, exchange traded funds (ETFs) are giving mutual funds a run for their money.

Launched in 1993, there are now 116 exchange-traded funds with assets of $93 billion. Equities make up 91% of the exchange-traded fund market; the rest is invested in bonds.

A recent report by Lipper, New York, said that ETFs pose a threat to the mutual fund industry. Net flows into exchange-traded funds in 2002 were positive in every month except December. Two of the three largest monthly inflows occurred during market bottoms in July 2002 and October 2002. By contrast, open-end mutual funds saw a net outflow in six of 12 months in 2002.

Matt McGinness, senior analyst with Cerulli Associates, Boston, said that the inflows into exchange traded funds during the bear market show the strength of that market. Exchange-traded funds assets went from $33 billion in March 2000 to $93 billion in February 2003, representing a 181% increase in assets. More recently, a Cerulli report said that exchange-traded fund assets grew more than 50%, considering a 20% decline in stocks in 2002.

Exchange-traded fund assets, however, pulled back 10% to $93 billion in February 2002 from $102 billion at year-end 2002. Both institutional and retail investors retrenched on their stock allocations due to concerns about the war in Iraq and the prolonged bull market. The biggest hit in the exchange-traded fund market was to QQQs (the Nasdaq 100), which registered an 89% decline in total return since March 2000. Nevertheless, overall, exchange-traded funds' asset growth was dramatic during the past 36-month decline in equities.

McGinness cited several reasons why asset growth has been strong during the bear market. Money poured into fixed-income ETFs when they were launched last year. Institutional investors and registered investment advisors used equity ETFs in hedging and arbitrage. They were shorting ETFs instead of using put options or short sales on specific stocks. The ability to use stop-losses and trading collars with exchange-traded funds was another reason assets grew. Meanwhile, market timers move in and out of equity exchange-traded funds based on their price trends and economic indicators.

"exchange-traded funds are ideally suited for market timers and tactical asset allocators," McGinness said. "They are being used by portfolio managers with actively managed index strategies."

The Cerulli report said that exchange traded fund growth is expected to continue - fueled on the retail side by financial advisers who manage money for the affluent.

"There is a growing interest among financial advisers for this product because of its low cost, interday trading and tax efficiency," McGinness said. "The interest is driven by Registered Investment Advisors and fee-only financial planners who are using exchange- traded funds as core holdings."

Although exchange-traded fund assets are growing at a tremendous clip, they have a long way to go before they put a dent in investment company products. Exchange traded fund assets are just 2.5% of total mutual fund assets, according to Investment Company Institute data.

Avi Nachmany, director of research of Strategic Insight, New York, minimized ETFs' competition to open and closed-end funds during the March annual meeting of the Closed-End Mutual Fund Association, New York. He said that institutional investors primarily are fueling exchange traded fund growth. Only about 10% of flows to exchange-traded funds can be attributed to retail investors.

Thomas Grzymala, CFP and president of Alexandria Financial Associates, Alexandria, Va., agrees that few financial planners are interested in exchange-traded funds. "However, they are good when one is creating a portfolio for a new client who has a goodly lump sum to invest. And I have had clients that don't want to invest in mutual funds because they pay year-end capital gains taxes on fund distributions even though their fund lost money," Grzymala said.

William Newell, president of Atlantic Capital Management, Holliston, Mass., said he began to use exchange-traded equity funds two years ago because research shows that after taxes, only 15% of actively managed equity funds outperform exchange-traded funds due to their low cost and tax-efficiency. The Standard & Poor's 500 exchange-traded fund (SPY) has gained a total of 133% since it was launched 10 years ago. But the fund has not paid out a capital gain distribution since 1996. It has only paid out 25 basis points in capital gains since inception.

He uses the large cap stock Fortune 500 exchange-traded fund (FFF) as a core holding. He builds a diversified portfolio around these exchange-traded funds. In the inefficient small cap and foreign stock markets, he uses actively managed funds because they can deliver higher returns. On the bond side, he buys individual bonds and ladders maturities.

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