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ETFs: An Unstoppable Investment Trend?

Posted by on Aug 3, 2010 in Investments | 0 comments

By George Klar

 

The other day at lunch, I asked a former executive for his views on who’s currently winning and losing within the investment industry. Without blinking, he said the clear winners are the Exchange Traded Funds (ETFs) while traditional mutual funds have lost some of their appeal.

He claimed it’s because ETFs charge lower fees, offer excellent daily liquidity and can replicate a host of passive, active or leveraged investment strategies. This is really no surprise. The Baby Boom generation is headed towards retirement amid widespread concern over finances. Controlling costs is a one key goal for the do-it-yourself crowd. Historically, mutual funds were critically important for newbie investor’s as they began their careers and families. But boomers today have access to free internet tools, are willing to self-educate and want greater autonomy over their financial affairs.

According to published reports, ETFs have grown at an annual rate of 25% over the past 5 years. By contrast, mutual funds have grown by only 5% during the same period. And much of this growth has come via automatic contributions from DC plans. Why the seismic shift in preference?

In the 60s and 70s, the economic landscape was dominated by accelerating inflation fuelled by wars, OPEC-led oil price shocks, expansionary fiscal policies and political unrest. Rising interest rates negatively impacted productivity and production. During this period, stock-brokers and their firms dominated the scene. Investors focused on assessing and buying equities (versus entire portfolios).

But transaction costs were high, trading volumes far lower than today and it was difficult getting accurate insights about companies.

The 80s and 90s ushered in a period of steadily declining inflation. This fuelled business investment, technological change, mergers and globalization. This in turn spurred competition and financial innovation. Large powerhouse mutual fund complexes had access to critical financial information (detailed analysis) and the benefit of trained, professional money managers. Mutual funds earned solid returns after fees while offering simple, turn-key total portfolio solutions.

By 2000, a new set of economic conditions had emerged. A technological revolution led to investment exuberance, an equity price bubble and its subsequent implosion. Then, the shock of 9/11 caused negative repercussions. To rekindle economic growth, interest rates were lowered and leverage was encouraged. This resulted in a shift towards riskier strategies and fuelled a boom for derivatives, hedge funds, private equity, illiquid assets and structured products. It eventually culminated in a systemic shock, triggered by the U.S. sub-prime meltdown, which resulted in a global credit crisis.

Today, technology and the internet make investing easier, faster and cheaper than ever before. Disillusionment with elected officials, corporate executives and financial markets are just some catalysts that explain why people are reasserting control over their finances.That’s why ETFs are winning investors’ hearts.

But is this a good thing? If investors pursue a trading approach with ETFs, emotionality could lead to performance shortfalls. This is what academics found had occurred with retail mutual fund investors. But it’s far too early to make any judgments yet. Meanwhile, many new ETF providers are entering the market with a wide assortment of offerings. So, expect strong ETF growth to continue.

George M. Klar is President, Alternativ Solution Inc. and he can be reached at george.klar@sympatico.ca.

This article is reprinted with permission. It originally appeared in the the August 2010 edition of AlternativChronicle.

 

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