Morningstar’s ETF expert, Scott Burns, sees a long-term shift to passive investing, but “managed solutions” packaging ETFs will also grow rapidly. 

The market plunge in 2008 was much harder to explain to investors in active-managed funds, says Burns, who directs ETF, Closed-End and Alternative Fund Research for Morningstar. As a result, many planners are switching to passive investments, especially exchange-traded funds. The move is part of an overall shift to fee-based planning practices, which he says, involve less hand-holding.

“Even during the massive outflows in 2008, passive investments still had inflows, both in stocks and bonds, “ Burns told Financial Planning. Passive investors kept investing and rebalanced their portfolios to maintain their allocations. “The big panic came with investors who had been sold on an active manager,” he said. “Even if you did better than the benchmark, the investor didn’t expect to ever have a losing year.”

Total U.S. investments in ETFs are approaching a trillion—about 10% of the total investment in mutual funds--and are greater globally. In their first decade, from 1994 to 2004, ETFs became a favorite for institutional investors. Between 2004 and 2006, they began attracting individual investors and advisors both for trading and for buy-and-hold strategies.  Today, ETFs account for 38-45% of the trading volume of the New York Stock Exchange and the major players—the SPDER (S&P 500), QQQ (Nasdaq 100), EEM (Ishares emerging markets)--are “more heavily traded than anything on the planet,” he said. Its now possible to trade ETFs for free at Vanguard and Schwab, and the lower fees make it possible to use ETF for dollar-cost-averaging approaches involving small amounts.  ETFs don’t carry sales loads and without a 12b1 fee, save another 20 basis points over a mutual fund.

ETFs offer the easy diversification, low expenses and tax efficiency of index mutual funds, along with the attractions of ordinary stock—the possibility of setting limit orders, short-selling or using options.

Although most ETFs are passive, there is a “nascent” move toward actively managed ETFs and rapid growth in “managed ETF solutions” with tactical structures that allow managers to pick up on momentum. “This will be the fastest growing area,” for ETFs, Burns said, predicting that in five to ten years the majority of advisors offering ETFs to their clients will use a “turn-key ETF solution.”  The strategies are getting good results in the academic literature, Burns said.

Will ETFs kill mutual fund companies? No, says Burns, because major mutual fund companies like Vanguard also provide ETFs. Some mutual fund companies that haven’t gone into ETFs are T. Rowe Price, Templeton and American Funds. Fidelity has been committed to active investing, but offers Ishares ETFs to its brokers.

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