One of the hottest selling areas in the mutual fund industry has been exchange-traded funds-so much so that asset managers anxious to enter the market are now developing proprietary indexes of their own on which to base such funds, launching niche sector or leveraged ETFs and even enhancing indexes, selecting from benchmark indexes companies with the largest dividends, revenue, cash flow or capital appreciation potential.

But ETFs threaten actively managed mutual funds, according to a report from Boston-based research and consulting firm Celent.

Due to expanding product range and the diversity of investors flocking to ETFs, the market is expected to grow six times over from its current $325 billion to $1.95 trillion by 2010, according to Celent. By comparison, the mutual fund industry has $9.5 trillion in assets, of which ETFs currently represent a mere 3.5% in assets.

But a number of developments in the mutual fund industry and inherent advantages to ETFs are driving their growth.

For one, asset management consolidation and business profitability reviews are causing some mutual fund houses to close funds. "When an individual gets shut out of a fund, they will start to look at other options and consider an ETF," said Denise Valentine, an analyst with Celent and author of the report.

The number of U.S. funds in April was 8,008, down from a high of 8,250 a decade ago. Cost improvements, shared operational services, and operational efficiency requirements will drive additional fund mergers and closures over the next year to 18 months, Celent predicts.

In addition, listed ETFs have a distinct advantage over mutual funds in terms of costs to shareholders. For large trades that are bought and held, ETFs avoid multiple trading expenses and provide a tax advantage for the investor. ETF managers also do not need to maintain cash balances for withdrawals or experience large cash balances through contributions, and, unlike mutual funds, ETFs remain fully invested and unaffected by other investor activity.

ETF fees vary, but are generally far less costly than mutual funds. They range between 15 and 75 basis points, compared to equity mutual funds that can sport fees between 77 basis points and 1.4%.

Although across most investment products, including mutual funds, fees have been declining due to regulatory actions, competitive pressures, better educated clients and improved automation and technology, investors will continue to flock to ETFs, according to Celent.

Investors also like niche ETFs to round out their portfolios, Valentine said. "They may be used in combination to create a diversified core portfolio or as components to provide further diversification into segments such as small-caps or commodities," she said. "Still others may use the vehicle for strategies such as tactical asset allocation, tax management, transition management or short-term trading."

It will be a slow process, but eventually the ETF industry will grow larger than the mutual fund industry, experts said. "The mutual fund business may still be as large as it is today, but ETFs will grow larger," said Greg Gastineau, principal of ETF Consultants of Summit, N.J. "This will not occur overnight. A lot has to happen to meet all the needs of investors that are currently met by mutual funds." There are liquidity issues and structural differences, he said, but eventually, ETFs will offer a full range of products and services and net sales of ETFs will exceed net sales of mutual funds.

In fact, Valentine believes more fund companies, particularly those that specialize in indexing, will enter the ETF market, although she does not expect a massive number of entrants. Some asset managers will avoid ETFs altogether, she added, fearing product cannibalism, as investors shift from higher-cost mutual funds to ETFs, thereby reducing the firm's overall revenue.

Fund companies also might not race to build the infrastructure to support a product that would produce lower fees, according to Celent. This may leave ETF issuance to the largest of firms, with deep resources, and to boutique firms that feel they have built a better mousetrap to attract significant sales.

On the other hand, some experts believe mutual funds will remain the predominant player in the industry. "There is a sense that ETFs have reached every spot of the market, and their exponential growth has to end at some point," said Jeff Tjornehoj, a senior research analyst with Lipper of New York. ETFs have grown at a far faster rate than mutual funds and are now entering a mature phase, he said.

"ETFs cannot compete with asset managers and the large portion of investors who are hypnotized by beating the index. ETFs will never beat the index. They will just match it," Tjornehoj said.

And while Celent predicts ETFs will continue to become ever more popular, Valentine conceded that ETFs are not for everyone. "Not all individuals will want to become active traders or set up brokerage accounts," she said. Additionally, mutual funds are the backbone of defined contribution plans.

"It would take a long time for ETFs to move into that market," she said.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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