Exchange-traded funds are variously seen as new products that will radically change the mutual fund industry or the latest novelty that will fleetingly appeal to fickle investors and then be forgotten.
Jack Bogle, former CEO and founder of the Vanguard Group of Malvern, Pa. and a pioneer in index investing, compared an exchange-traded fund to a "finely crafted shotgun" at a Morningstar conference late last month in Chicago. The shotgun could be used for "hunting, protection or suicide," he said. The average holding period for Nasdaq exchange-traded funds is only three days, suggesting that most investors have recently been using exchange-traded funds to commit suicide, Bogle said. The funds offer some enhancements over traditional index funds but foster market timing, he said.
But exchange-traded funds could be the most significant new products of the decade, according to a recently-released study by Financial Research Corp. of Boston. By 2007, assets held in exchange-traded funds could be between $445 billion and $1 trillion, the study said. Developers of exchange-traded funds and financial planners and brokers who currently use exchange-traded funds in their client's portfolios were polled for the study. They estimated that exchange-traded funds will grow between 30 percent and 50 percent annually over the next five years.
Despite claims by Bogle and others that exchange-traded funds are tools for momentum traders and market timers, 75 percent of the retail investors polled for the study claimed that if they were to buy exchange-traded funds, they would use them as long-term investments. The remaining 25 percent indicated they would use them for a combination of long-term and short-term trading strategies. Nearly 800 retail investors were surveyed for the study.
While exchange-traded funds are seen as potentially commanding enormous sales, there are a number of hurdles the products must overcome before they are widely accepted by investors, the study said.
Getting exchange-traded funds expeditiously approved by the SEC is the greatest obstacle to the future success of the products, according to 62 percent of the brokers, planners and product developers polled for the study. From initial application to final SEC approval for all types of exchange-traded funds, it takes an average of 16 months and initial applications have to be amended an average of three times for each type of fund, the study found.
The process is also costly, said Mary Joan Hoene, an attorney with Carter Ledyard & Milburn of New York.
Currently, a company seeking to offer an exchange-traded fund must obtain an exemption to a prohibited transaction from the SEC. To simplify and expedite the process, the SEC would have to eliminate the requirement that the exemption be obtained and approve the products by the same process it uses for approving traditional open-ended funds. But, the SEC is not likely to do that for two or three years, Hoene said.
Pricing competition is another hurdle many firms are facing regarding the product. Exchange-traded funds' fees are half of those of the average index fund and one-third to one-fifth of those of actively managed funds, according to the study.
An actively-managed exchange-traded fund that would include a management fee could provide greater profit margins, but there have been no filings for such products. Most of the brokers, financial planners and product developers polled said such a product would take at least two years to develop and launch.
Currently, the only firms whose business is threatened by exchange-traded funds are those that offer traditional index-funds, closed-end funds and unit investment trusts, the study said.
Because of the high cost of launching exchange-traded funds, a few large firms are likely to offer a range of such funds and smaller firms will offer a single product, the study said.
