While the bulls ran, exchange-traded funds (ETFs) boomed. From late 2002 to late 2007, while U.S. stocks doubled and foreign markets did even better, ETFs went from being a curiosity to a household word. By the end of 2007, there were 629 domestic ETFs with $608 billion in assets, up from 280 ETFs with $102 billion in assets at year-end 2002, according to State Street Global Advisors (SSgA).

This year, of course, stocks have been stunned. Yet total assets in ETFs were down only 4.2% through August 2008, according to SSgA. Moreover, 81 ETFs were launched in the first eight months of the year, attracting new cash from investors. The impact of the equities market shocks in September and October on ETF asset accumulation isn't yet known; and what the impact of the change in the general investment climate this fall will be on ETFs is anybody's guess.

Widespread Acceptance

Yet during the first eight months of this turbulent year, some types of ETFs gained widespread acceptance. These include ETFs for:

• Fixed income. According to Anthony Rochte, a senior managing director at Boston-based SSgA, in early 2007 there were only six fixed-income ETFs in the U.S. "So many new ones have been introduced since then that there are over 50 now," he says. Through August 2008, total assets in fixed-income ETFs were up 40% for the year.
• Commodities. As financial planners and their clients know all too well, the price of oil and other commodities shot up through 2007 and during the first half of 2008. Even after prices backed off last summer, assets in commodity ETFs were up more than 7% for 2008 through August. "Individual investors continue to gain access (long and short) to commodities that had been difficult to reach," says Tom Lydon, president of Global Trends Investment in Newport Beach, Calif., and editor of ETFtrends.com. Even though exchange-traded notes (ETNs) gained some market share, their appeal is now in doubt, as these investments are essentially backed by insurers who are typically financial firms. So investors' appetite for them has diminished.
• Currencies. Weaknesses in stocks were mirrored by those in the dollar for most of 2007 and 2008 before the dollar rallied last summer. As currency ETFs have given American investors an opportunity to profit from the diminished buck, seven have been launched in 2008, bringing the total to 18. Assets in currency ETFs increased 40% this year through August. (ETNs are a currency alternative, but issuers may encounter a lack of enthusiasm for such offerings.)

  "Currency ETFs also act as diversifiers for cash," says Ed Lopez, director of ETF strategies at Rydex Investments of Rockville, Md. "Many of the foreign currencies offered through ETFs are not correlated to the U.S. dollar." However, notes Lopez, clients may want to hold currency ETFs in tax-deferred retirement accounts. The IRS has ruled that financial products linked to a single currency (including ETFs and ETNs) will be taxed as bonds are. Accrued interest is currently taxable, and profits on sale are treated as ordinary income rather than long-term capital gains.

• Inverse/leveraged. By far, the biggest winners among ETFs in percentage terms have been those that allow investors to bet against the broader market, to double up on these bets or both. SSgA puts 78 ETFs in this category after the addition of 16 this year. Assets year-to-date through August are up up 134%, to $22.5 billion.

Safe Havens

In absolute terms, fixed-income ETFs gained slightly more assets than inverse/leveraged ETFs in the first eight months of 2008—$13.8 billion compared with $12.9 billion. Rochte calls fixed-income ETFs a "natural product extension." By 2007, major equity indexes were all tracked by one or more ETFs, so fixed-income seemed to offer the best opportunity for ETF sponsors. Major players such as SSgA and Vanguard launched products, joining Barclays Global Investors (BGI), which had been offering several fixed-income iShares.

Moreover, the surge in fixed-income ETFs probably owes a great deal to the financial climate over the past two years. The weakness in stocks and the expectation of continued economic uncertainty have increased investors' appetite for bonds, the most basic—and perhaps the most effective—diversifier for stock-heavy portfolios. "Driving the growth in fixed-income ETFs has been a desire for protection from inflation," says Matt Tucker, head of investment strategy with the fixed-income group of BGI in San Francisco. "Even though oil prices have retreated recently, inflation is still a real concern for many people." Therefore, assets in ETFs that hold Treasury Inflation-Protected Securities (TIPS) and other inflation-linked notes or bonds have increased substantially.

Turmoil in the credit markets also has drawn investors to fixed-income ETFs. "Short-term Treasury ETFs have become more appealing in reaction to problems of auction-rate securities," Tucker says.

For years, auction-rate securities had been perceived as a higher-yielding alternative to money market funds. Now that the market for auction-rate securities has collapsed, short-term Treasury ETFs may fill that void, although there is a risk of a price decline. "There [has also been] a great deal of interest in fixed-income products outside the U.S.," Tucker says, referring to ETFs that hold foreign bonds.

Cost Cutters

As planners and clients have paid more attention to bonds, they've noticed the advantages of fixed-income ETFs. Bond ETFs with expense ratios as low as 13 basis points are appealing, compared with bond funds that typically have much higher expenses, Rochte points out.

"With yields low, expense ratios are in focus," Tucker adds. He points out that there are few bond index mutual funds that might be expected to have low costs. If bond yields are in the 4%-to- 5% range, paying 0.94% (the average expense ratio for a general bond fund) can put a huge dent in clients' returns, so low-cost bond index ETFs may have their advantages. What's more, most active managers underperform fixed-income benchmarks, Tucker says. Therefore, many investors and advisors have turned to fixed-income ETFs that promise the benchmark return minus a few basis points.