In the "new normal" that follows this recession, exchange-traded funds will be ideally positioned for a new world of lower expenses, lower returns and exposure to a wide variety of asset classes, experts say.

"Bring your standards down for what you expect," said Bill Gross, managing director and co-chief investment officer of Pacific Investment Management Co., at an online webinar titled "ETF Insights" last week. A return of 3.5% isn't a lot of money, he said, but it's better than the 0.01% that some money market funds are yielding.

"The new normal is likely to be a significantly lower-returning world," Gross said. "Diminished growth, deleveraging, and increased government involvement will temper profits and their eventual distribution to investors in the form of dividends and interest. As banks, auto companies and other corporate models become more regulated and therefore more like utilities and less like Boardwalk and Park Place, they will return less."

The legendary fund manager praised ETFs for their low expenses, high liquidity, tax efficiencies and transparency, and said PIMCO is planning to expand its ETF base. Last week, it introduced an actively managed municipal bond ETF, the PIMCO Intermediate Municipal Bond Strategy Fund, betting that the new economy will rely on lower, more-reliable returns.

"A 65-year-old Baby Boomer needs inflation protection," Gross said. "If a retiree can't afford to lose much money, you have to advise them into stable, fixed-income investments and utility stocks. [Treasury Inflation-Protected Securities] make some sense from the standpoint of insurance. They're not meant to make you get rich, but to stay rich. You don't buy collision insurance in anticipation of an accident, but just in case."

Gross said PIMCO manages about $431 million in ETF assets and plans to expand on this.

Gross admitted that PIMCO missed an opportunity to invest in ETFs earlier.

"We should have been there 15 years ago," he said. "Put it on my shoulders."

As for his outlook for the recovery, Gross said, "Modest investment returns in almost all areas will make it necessary to keep expenses low. The expectation of a V-shaped recovery can't possibly be correct relative to the changes that have taken place in the last 12 months. PIMCO suggests that economic and profit growth will be half of what it was."

There are now 1,859 ETFs worldwide, with many listed on multiple exchanges, said Deborah Fuhr, managing director and head of ETF research at BlackRock. Collectively, ETFs hold $941 billion in assets, less than 10% of mutual fund assets.

"ETFs were originally embraced by trading desks and hedge funds," Fuhr said. "They used to be the only product you could short even when the price was going down. The toolbox has grown significantly."

ETFs provide exposure to everything from individual commodities to specific sectors to broad-based indexes. They can be used by active and passive managers in both the retail and institutional space, Fuhr said, but at its core, a true ETF is a mutual fund with its assets held by a custodian.

"ETFs provide easy access, not easy work," said Roger Nusbaum, a financial advisor at Your Source Financial. "ETFs are basically just a tool. Sometimes they're the single best tool to capture a certain country or sector."

Most ETFs are designed to allow a buy-and-hold investor the ability to track a benchmark with high transparency at a low cost. Their ability to trade throughout the day offers investors ample doses of liquidity, but most ETFs don't have to be traded often to work.

Other products like leveraged and inverse ETFs are designed to magnify gains and losses, and can be extremely volatile and unpredictable. These tools are designed for tactical managers who like to slip in and out of areas with laser precision. For the average investor, these tools are way too powerful, but as tools, they're only as dangerous as the person handling them, Nusbaum said.

"Tactical investing is not for everybody," said Dan O'Neill, president and chief investment officer at Direxion Funds. "Our products are specifically targeted to tactical managers. You have to monitor your portfolio frequently and make frequent changes."

O'Neill said the turnover of shares was extremely active among some ETFs earlier this year, with turnover rates of 800% a day during critical periods.

"The overwhelming majority of users have used these products well, but some people will just dive into things," he said.

The nearly 1,900 different choices of ETFs are confusing and overwhelming fund managers and financial advisers who can't see the difference between similar products.

"There is a bit of a land grab in the ETF space right now," said George "Gus" Sauter, chief investment officer at Vanguard.

Some ETFs provide exposure to very narrow market segments, but they often fold if there is not enough investor interest, he said.

"Many ETF products are very similar," Fuhr said. "In some of the benchmark areas, I think we do have too many products. This does not necessarily mean the area is saturated, but it is very challenging for new entrants to get a foothold."

Experts urge investors to carefully study any ETFs they are considering. Often the older, larger ETFs can provide everything an investor wants, but in some cases, specialty ETFs are better suited for specific needs.

There is a growing interest in fund-of-ETF products, Fuhr said, and many managers are wondering how to get ETFs into 401(k) plans.

"It would be beneficial if there was an easier way to allow ETFs to be in 401(k)s," she said. "Can ETFs sit within 401(k) plans? I don't see why not, but surprisingly, a lot of 401(k)s don't [offer] index funds."

Many experts worry that increased regulatory scrutiny will slow the introduction and innovation of new ETF products, and current transparency requirements are better suited for passively managed ETFs, rather than actively managed ones. Passive ETFs are usually designed to match their benchmark, whereas active ETFs are meant to beat their benchmarks.

ETFs are required to give investors a clear, daily view of the funds, but some active managers worry that too much transparency could give away all their secrets.

"There is a collision between trying to maintain transparency and trying to maintain the integrity of a portfolio," Sauter said. "You run the risk of people trying to front-run you. This is a hurdle for active management to overcome."


(c) 2009 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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