The truth is, these two products coexist in most portfolios.
While much of the growth in ETFs has come from retail users, surveys show that most advisors are employing at least some ETFs as well. "It's very rare that I don't include ETFs in client portfolios," says Ken Robinson, owner of Practical Financial Planning in Cleveland. "For passive investments, I almost always find myself using ETFs now. Even when you factor in the trading costs, they're typically less expensive than other options."
Indeed, most advisors use both ETFs and mutual funds, says Anthony Rochte, senior managing director of Boston-based SSgA Funds Management. SSgA is both the second-largest ETF provider and a major player in the traditional mutual fund business.
Some industry watchers, though, think that pitting ETFs against traditional open-end mutual funds is a meaningless face-off. "A lot of times these comparisons of ETFs versus funds mask other things," says Joel Dickson, principal and senior investment strategist at Vanguard, one of the two biggest mutual fund companies and the third-largest ETF sponsor.
Dickson says that the choice between ETFs and open-end mutual funds has been driven not by the structure of the investment, but by "the distribution platform available to the advisor." Before ETFs, commission-based advisors had no access to the indexing giant's portfolios. Vanguard has never paid for distribution on its mutual funds, Dickson says.
But the company's ETFs are available on brokerage platforms, making it easy for both commission- and fee-based RIAs to use them in portfolios. "That's in many ways why the ETF has blossomed in the financial advisor community," he says.
Most ETFs today are index funds. As a result, some planners shun them as core holdings because of current market conditions. "Right now, we're more on the managed equity side than on the indexed equity side," says Jim Holtzman, an advisor and shareholder with Legend Financial Advisors in Pittsburgh. "We don't want to get into indexes right now," he adds, citing market volatility.
Holtzman uses ETFs as tactical tools to provide exposure to areas that can't be accessed efficiently through traditional mutual funds. Mostly he uses gold, coal and agribusiness ETFs in more aggressive portfolio strategies.
In contrast, Robinson avoids anything that might be considered a novel ETF. "I'm not an early adopter," he says. "The ETFs that I use tend to be with companies that have been doing indexing a long time and they're very boring and garden variety."
Although Robinson sometimes uses actively managed funds, he usually opts for indexed portfolios. It's a preference that his clients share. "If they have a strong opinion that it's all about active management, they probably wouldn't be my clients," he says.
Does the choice come down to passive strategies versus active ones? Rochte thinks not: "The conversation is less about indexing versus active," he says. "I think there's been a bit of a mischaracterization of terms," adds Dickson. "ETFs do not have a one-to-one correspondence with index," he says, noting that his firm's sales of open-end index funds have been strong. Much of the firm's growth in open-end index fund sales has been in the defined contribution market where target-date portfolios have become increasingly popular.
Because of the preponderance of indexed products in the ETF universe, it's likely that advisors favoring active management may have to construct client portfolios around open-end funds.
Rochte predicts growth ahead in the active ETF market. He explains that initial growth will come in the fixed-income ETF space because bond managers are more likely to feel comfortable about disclosing their holdings.
Understandably so, since in the huge, opaque fixed-income market it would be more difficult to copy a manager's strategy than in the more transparent equity market. Meanwhile, higher ETF trading volume last year suggests that advisors are using passive instruments to implement active management strategies such as sector rotation.
Morris Armstrong, owner of Armstrong Financial Strategies in Danbury, Conn., takes a core-and-satellite approach with client portfolios. In a typical portfolio, he estimates, ETFs are 20% to 30% of client assets. Armstrong likes the flexibility of the ETF structure. If he decides to take a position in the morning, he doesn't want to wait until 4 p.m. to see the strategy implemented.