In the first five years of this decade, assets in equity exchange-traded funds (ETFs) increased by a factor of six, easily topping $200 billion. Over that period, assets in index-tracking equity mutual funds increased by about 29%. And actively managed equity funds? They grew their asset base by just 6%.

Does this mean that the actively managed stock fund's time has come and gone? Of course not. Investors lost confidence in the fund industry and in many fund families in particular in late 2003 and 2004 following the revelations that some executives had allowed hedge funds and even insiders to profit from mispricing within the funds. ETFs were the primary beneficiary of that loss of confidence, pulling in a net inflow of $55 billion in 2004. But clearly investors have been selective, and a number of fund firms with an active bent have attracted assets quite successfully in the post-Eliot Spitzer period (these include American Funds and Dodge & Cox).

Scandal is certainly not the only reason for the success of ETFs, though. And asset management firms will benefit by studying the ETF marketing playbook. ETF growth is likely to continue, and that is good for investors and for the ETF industry, but that growth does not have to be at the expense of actively managed mutual funds.

So what have ETF sponsors been doing well that mutual fund sponsors can emulate?

Savvy Marketing, Smarter Advisers

Most ETF advertisements (and there are many) don't focus on recent performance. They focus on either the asset class to which they offer exposure, or on the ways that financial advisors can reinvent themselves by adding ETFs to their product mix. They capitalize on two important trends: 1) the increasing desire of sophisticated investors to diversify into less-traditional asset classes, and 2) the brokerage industry's struggle to move away from preferred-product distribution and towards conflict-free service to clients.

One prominent fund family CEO told financial journalists last fall that the only education his firm would provide to shareholders was to explain the meaning of two words: "diversification" and "rebalancing." The fund industry has invested very little in education, although some firms have sponsored advisor seminars that offer continuing education credits for Certified Financial Planners. ETF sponsors and exchanges have been much more aggressive at getting the word out, particularly to advisors. And the focus of their educational effort has been to help advisors actually implement an ETF strategy, not simply on the mechanics or legal structure of the product.

Fund executives may protest that they cannot directly measure the return on an educational investment, but it is clear that ETFs have seen an excellent ROI. The right approach, although it is counter-intuitive, may be to sponsor investment education that does not focus on a particular firm's products. The brand benefit to this approach is powerful.

Nimble Product Development

ETF sponsors have demonstrated a solid knack for quickly tapping into investor demand and responding to market dynamics, developing products that meet and even anticipate investor and advisor demand to reach those asset classes. This has been evidenced by the rapid launch of ETFs that efficiently expose shareholders to gold bullion, inflation-protected TIPS bonds, Chinese equities, and other hot asset classes. Advisors of actively managed funds have the flexibility to meet the current interest in absolute-return streams and non-correlated products, and to anticipate other sources of demand before they emerge.

ETFs have been exceptionally popular with affluent investors, since they tend to be tax efficient. Most actively managed funds, on the other hand, are managed without regard for taxes and it shows, as a high-tax-bracket shareholder of a typical bond fund gave up about 38% of the fund's load-adjusted return over the past decade to the IRS. Tax management techniques such as loss harvesting and selling high-basis shares first do not necessarily compromise the fund's pre-tax return. Firms that are successful in minimizing the tax hit can advertise their after-tax returns, highlighting both the post-tax returns and their Lipper Leader rating for Tax Efficiency.

Expanding the Investor Base

ETFs have successfully targeted institutional investors, advisors and portfolio managers who are used to trading individual securities. Mutual fund firms have expanded to reach about half of U.S. households, but there is room for continued growth. Funds have relatively low penetration within many ethnic groups, including ethnic groups that have very strong or improving economic fundamentals.

According to the Investment Company Institute's excellent "Profile of Mutual Fund Shareholders" paper published last year, just 6% of U.S. fund shareholders are African-American, 5% are Hispanic, and 2% are Asian. Those are numbers that may be out of step with the changing wealth locus of our country.

Fund firms should consider specialized marketing and educational efforts to target these audiences. Fund sponsors can grow their investor base by successfully tapping into the looming need for retirement savings that affects Americans of every ethnicity.

Integrity, Sensibility, Efficiency

ETFs took market share away from active funds in 2003 and 2004 because ETFs are resistant to abuses stemming from stale asset prices. The time is right for funds to highlight the advantages of their structure and strong regulation in order to compete effectively against emerging competitors, especially separately managed accounts (SMA) and hedge funds.

Mutual funds can highlight that they are highly regulated and transparent. They offer reasonable fees. The customization element of SMAs is important to some investors, but many SMA accounts are never customized. Actively managed funds are not handcuffed to a capitalization-weighted index, unlike most ETFs, and the active manager can underweight or sell stocks that see their market cap increase faster than their business prospects.

And there is no reason why mutual fund firms can't successfully market more hedge-style funds that pair the transparency and reasonable expense of mutual funds with the modest standard deviation and non-correlated returns that hedge-fund investors desire.

ETFs offer exposure to an entire asset class with one trade. But so do mutual funds. And with mutual funds, there is no need to pay a $20 brokerage commission every month when a shareholder invests an additional $100 into the fund (a $5 front-end load is perhaps more typical for a fund investor).

For many investors, who sensibly practice dollar-cost-averaging, mutual funds are efficient. In addition to highlighting this advantage, firms need to keep a focus on providing reasonable expenses; this will make their products more competitive versus ETFs, SMAs and hedge funds. Individual investors may not pay much attention to expenses when investing on their own, but experienced advisors are more likely to do so now. And increasingly, analytical firms and personal-finance Web sites are helping investors to see the impact that taxes and expenses can have on their returns, with news stories, online calculator tools, and ratings like the Lipper Leader ratings for Expense.

The time is right for actively managed funds to really grow their asset base and to leverage their many advantages over their competitors. ETFs have been the beneficiary of being the popular new kid on the block, but they have also facilitated their asset growth by doing many things very well. Funds can benefit by looking at the ETF marketing playbook and improving on it. A fund industry that educates consumers and advisors, serves and anticipates their needs, and communicates well to the broad base of Americans is an industry that has lots of room for continued growth.

Robin Thurston is vice president and global director of Research at the Denver-based fund tracker Lipper.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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.