Besides the dreaded fiscal cliff, U.S. investors have another big event looming in January 2013 … but this one calls for a party!
January is the 20th anniversary of the first U.S. exchange traded fund (ETF) listing — the SPDR S&P 500 ETF (SPY) — and we’ve come a long way since then. Almost two decades later, ETFs have altered the way individuals and professionals invest.
Total U.S. ETF assets (including all types of exchange traded products) exceed $1.3 trillion, with more than 1,400 funds to choose from, according to a recent report from The Wall Street Journal.
And while traditional U.S. equity mutual funds hemorrhage cash with steady monthly outflows, ETFs keep on attracting new cash from investors at a clip of more than $100 billion per month, in spite of volatile markets.
How to Build a Diversified
Portfolio with ETFs
Record ETF inflows make it clear that investors aren’t so much abandoning the stock market as they are embracing a new form of stock ownership.
After all, ETFs can be a much easier and more cost-effective way to invest in an entire asset class; stocks, bonds, commodities, currencies, you name it. The key advantages to using ETFs are widely known:
• Costs: The average expense ratio for ETFs is just 0.5 percent, compared to 1.4 percent for actively managed U.S. mutual funds — a big difference that is difficult for mutual fund portfolio managers to make up.
• Performance: While many portfolio managers routinely fall short of the benchmark in terms of performance, after higher fees and expenses, ETFs are designed to more closely track their benchmark index often leading to superior performance.
• Variety: The large number of ETFs available allow you to zero in on specific sectors (energy, technology, REITs, etc.), investment strategies (large-cap, small-cap, growth, value), and any region around the world (U.S., Europe, emerging markets, etc.).
In other words, you can get pretty specialized with your investment strategy these days, making ETFs a great alternative to individual stock-picking. This is especially important if you are an individual investor who may not have the resources to build a properly diversified portfolio using individual stocks and bonds.
But it’s not just individual investors leading the charge into ETFs. In fact, some big mutual fund companies including Fidelity, John Hancock, and Legg Mason are deciding that if you can’t beat ‘em, join ‘em … by investing in ETFs within their own mutual fund portfolios.
Two emerging trends in the industry are especially exciting for ETF investors and worth keeping tabs on.
Trend #1 —
Actively Managed ETFs
Most ETFs today still track specific indexes, like SPY which aims to replicate the performance of the S&P 500 Index for example. But we may soon witness the launch of many more actively managed ETFs after the successful introduction of one high profile active ETF earlier this year.
In March, fixed income mutual fund giant PIMCO launched the PIMCO Total Return ETF (BOND). It’s essentially a clone of its popular mutual fund by the same name. But this ETF is actively managed, similar to a traditional mutual fund.
BOND has been a big hit with investors so far. In fact, it has been one of the most successful new ETFs ever launched, raking in over $3 billion in assets already. Name recognition has probably helped, but so has superior performance.
The total return of 8.25 percent for BOND over the past six months easily beats its benchmark, the Barclays U.S. Aggregate Bond Index, which is up just 3.68 percent. Not surprisingly, BOND is also outperforming the PIMCO mutual fund of the same name.
Trend #2 —
Managed Money Attracted to ETFs
During my tenure at Weiss Capital Management, our former investment advisor affiliate, we were early adopters of managed account investment strategies for our clients using ETFs rather than mutual funds or individual stocks.
Today, more advisers than ever are offering ETF strategies to their clients. According to Morningstar, ETF managed portfolios offered by investment advisers held total assets of $50 billion at the end of June, up 48 percent since last year!
But the big-game that ETF providers are really trying to bag is defined contribution retirement plans, such as 401(k)s. Unfortunately, mutual fund companies still have a hammer-lock on this $3 trillion industry, but that may be about to change.
At the end of last year, ETFs accounted for only 0.2 percent of total assets in U.S. 401(k) plans, compared to traditional mutual funds with a 53 percent share of the market.
Too many traditional mutual fund based 401(k) plans offer a limited menu of investment choices, often restricted to funds from just one mutual fund provider. Plus, mutual fund based 401(k)s suffer from the same performance anxiety that dogs all mutual funds, with returns often falling short of the benchmark, after fees and expenses.
Now, big players in the industry are making a push to add lower-cost ETF based options in 401(k)s. Charles Schwab, a big 401(k) administrator, is developing ETF-only plans that should be available by 2014. And Fidelity Investments, still the giant among actively managed mutual fund firms, is now making a renewed push into ETFs.
Bottom line: Today it’s easier than ever before to build a diversified global investment portfolio using just a handful of carefully selected ETFs. And considering the edge they have enjoyed in terms of lower-cost and superior performance over traditional mutual funds, it’s no wonder why ETFs have enjoyed such spectacular asset growth in just 20 years.
And the best is yet to come!
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