So much for not selling at the bottom. October 2008, unequivocally Wall Street's worst month of the financial crisis thus far, saw more cash pulled out of long-term mutual funds—stocks, bonds and hybrids—than any other month in history: $127.55 billion. It was twice the $63.82 billion outflow seen in September, the second worst month ever, according to the Investment Company Institute (ICI).

Of October's total, 57%—or $72.44 billion-came out of equity funds, reports ICI. In September 2008, the month that saw the bankruptcy of Lehman Brothers and the bailouts of Freddie Mac, Fannie Mae and AIG, 88% of the outflows-that is, $56.36 billion—came out of stock funds. Although outflows began to slow in the final months of the year, the trend continued.

That's a lot of money to be swirling around. Yet while asset values fell, and cash poured out of mutual funds like water from a broken main, ETFs experienced net cash inflows. In 2008, $245 billion poured out of equity mutual funds alone, while $140 billion net cash entered equity ETFs, according to TrimTabs Investment Research. Much of those equity fund outflows went into money market funds. Still, for every two dollars that exited equity mutual funds, equity ETFs took in more than $1.

Are ETFs really cannibalizing 50% of mutual funds' assets? That may be doubtful, but the number could be as high as 25%, say analysts. ETFs' distribution crosses various markets, thus making it difficult to establish a correspondence among the money flows. State Street Global Advisors, the firm with the largest ETF in the world, the SPDR S&P 500 ETF (SPY), estimates that half of all ETF assets reside with traditional institutional firms, 35% to 40% come from the retail clients of investment advisors and the rest from self-directed investors.

A Mixed-Use Product

"The thing with ETFs is that they're not a retail-only product," says TrimTabs analyst Vincent Deluard. Mutual funds began seeing net redemptions in the middle of 2007, he says, while ETF inflows didn't pick up until the end of 2008. Deluard, who believes that a lot of the mutual fund money is going into ETFs, notes that the sectors that saw the most cash inflows were the short ETFs that capture the inverse of the market's move, the high-yield bond group and ETFs with moderate allocations.

"We finished the year with $64 billion in net cash inflows, about $15 billion of that in December alone," says Anthony Rochte, senior managing director of State Street Global Advisors. The SPDR ETF family finished the year up $1.7 billion over a year earlier. "Advisors are in a very difficult environment and are using ETFs to tax-loss harvest," Rochte says. "This past year we only had 10 ETFs that were net negative in terms of cash flows." Those were mainly among international ETFs, especially emerging markets and China-based ETFs.

Tricky to Track

One problem with tracking ETF inflows is that there's no definitive way to identify individual shareholders. Mutual funds have transfer agents who track the entry and exit of every dollar in the fund. Few institutions use mutual funds; most investors are individuals. ETFs, on the other hand, only sell or redeem shares with a broker or specialist, known as the authorized participant. After creating new shares, the authorized participant then sells them on the secondary market. Thus, the ETF has no knowledge of who holds its shares.

No doubt, some money entering ETFs isn't coming from mutual funds. ETFs that match futures, such as the SPDR S&P 500, and the Dow Diamonds (DIA), which tracks the Dow Jones Industrial Average, are traded heavily by institutions such as pension and hedge funds.

Why ETFs

However, ETFs with specialized portfolios receive money mostly from retail investors. While small, those inflows have remained steady over the past year. Gary Hager, the president of Integrated Wealth Management, an Edison, N.J.-based financial services company, says this is especially true for alternative assets not correlated to stocks and bonds, such as commodities and currencies. ETFs—or in some cases, exchange-traded notes (ETNs)—act as a proxy for investors wishing to invest in these hard-to-access areas that just a few years ago were unavailable or required a lot of money to diversify.

"There's something else people are missing: what's not happening with ETFs," says Scott Burns, Morningstar's director of ETF analysis. "People aren't selling. Not only are people leaving stocks and mutual funds to buy ETFs, the people who own ETFs are also not selling them."

Burns acknowledges similar behavior among investors of index mutual funds, the few long-term mutual funds still seeing positive fund flows right now. These investors are sticking to their guns, he says, since index funds typically pick up market share during downturns.