Exchange-traded funds could turn out to be "the most significant new product category" of the decade, according to Financial Research Corp. of Boston. They will "continue their recent dramatic growth rate for many years to come," according to a recent FRC report. Any fund complex that wants to appeal to a broad investor base should probably add the products to its offerings, the report said.

"Clearly, index-based ETF's are about to break through into the mainstream-investing world," FRC said in its report, "Exchange-Traded Funds: An Emerging Alternative to Mutual Funds." But that does not mean that they will eclipse mutual funds, FRC said.

FRC predicted that exchange-traded funds, which currently have $40 billion in assets under management, will not turn out to be the "killer app" that eradicates mutual funds. Instead, exchange-traded funds will probably enjoy comparable prominence that index funds and supermarkets have gained in their respective spheres, FRC said.

Just as broad-based fund companies have added index funds to their lineups and have expanded their distribution channels to include supermarkets, fund companies with general mandates should probably add exchange-traded funds to their offerings, FRC said.

Because of their low fees - half the cost of index funds and as little as one-fifth the cost of actively-managed funds - exchange-traded funds could give fund companies an opportunity to bring back individual investors who have left pooled investing in favor of the low costs of discount and on-line brokerages, FRC said.

In its report, FRC recalled the concerns raised when index funds were introduced in the early 1980's that they would supplant actively-managed funds. In spite of these concerns, these passively-managed, low-fee products have only attracted 10 percent of total equity fund assets, FRC said. Similarly, "supermarkets have not come close to eliminating old-model distribution of mutual funds," FRC said.

"Index funds and supermarkets did not undermine the industry, but rather contributed to its rapid growth, and enhanced its ability to evolve and adapt to the needs of the investing public," FRC said. "We expect that ETF's will follow the same pattern."

FRC offered a number of suggestions to firms thinking about offering exchange-traded funds.

The first was not to expect much profit. Any firm deciding to get into the exchange-traded fund business will have to realize that the nine-to-30-basis-point fees that these products command will yield very low margins, FRC said. For many fund companies, exchange-traded offerings will prove expensive, FRC said.

"Fee rates at these levels will mean that only a handful of firms with extremely large scale will be able to manage index-based ETF's profitably on a stand-alone basis," FRC said.

However, if a firm is thinking about offering an exchange-traded fund, the earlier it does so, the better, FRC said.

"The timing of index-based ETF product development will be critical," FRC said. "Early adopters will likely benefit from a substantial first-mover' premium . . . from a groundswell of free media coverage, and the opportunity to brand a firm as an innovator in a culture that seems to idolize innovation."

"Firms that want to exercise market leadership should consider beginning an active research effort now in preparation for ETF development down the road," FRC said. "This is true even if firms don't see themselves as indexers."

There is a possibility that actively-managed exchange-traded funds will come to market as early as 2002, FRC said. Firms that determine how to offer an actively-managed exchange-traded fund without tipping their hands to the holdings in these funds will do very well, FRC said.

FRC projects an enormous increase in actively-managed exchange-traded fund assets. In the first year alone that actively-managed exchange-traded funds are offered, they could garner nearly $60 billion and could build to nearly $500 billion by 2007, FRC said.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.