BULLS & BEARS: Why ETFs are gaining on mutual fund industry

The big election is 18 months away. Is there an investment you can use to play it?

I think so if you look to a rising star that is attracting the attention of the wealthy as well as the common man. This star’s popularity has gone from relative obscurity a decade ago to a media frenzy now.

If this were 1958, you would think I was talking about JFK, and today Obama comes to mind. But I’m not thinking of either of them.

I am describing the rise in popularity of exchange traded funds, and, much like President Kennedy, they are better known by their initials ETF.

The first ETF has hardly hit adolescence, as it started trading only 14 years ago. There now are more than 425 of them, with $450 billion in assets, and many more in registration.

The mutual fund industry has taken notice of the rapid growth of the new kid on the block. Although ETFs are growing like the weeds in my flower beds, they are still pipsqueaks when compared with the size of mutual funds. ETF assets of $450 billion seem big, but the market share of mutual funds dwarfs them at $11 trillion, 25 times as much in assets.

Because of this size difference, some mutual fund executives aren’t particularly concerned by the fast growth of their competition. Maybe the mutual fund leaders should look back to 1965, when pot-bellied, cigar-chomping GM execs blew off a new kid in the market with the funny name of Toyota. ETF assets have taken only 14 years to attract the same dollars mutual funds labored 60 years to attract.

What is the attraction for the rapid growth?

An ETF is just a share of a basket of stocks. That’s much like a mutual fund except the ETF basket has some inherent advantages. Generally, ETFs have a significantly lower cost of ownership than their mutual fund competition.

They also rarely surprise you at tax time with capital gain distributions. In fact, some ETF sponsors have never declared a capital gain from any of their funds. ETFs are liquid with a point and a click any time markets are open instead of just at the end of the day. ETFs are transparent in that they disclose their portfolio holdings daily.

In contrast, many mutual funds are like Forrest Gump’s box of chocolates in that “you never know what you’re gonna get.”

ETFs can be shorted, which might not be a big deal to the average investor, but it is a huge deal to hedge funds. ETFs also are available through any broker with just the cost of a stock commission to buy. There are no front-end loads, back-end loads, 90-day minimum holding periods, or minimum investment amounts that are typical with many mutual funds.

All these advantages help explain ETFs’ rapid rise to stardom.

Like a typical politician, I haven’t answered the question of how to play the next 18 months. Tough. I’m not running for office, so you’ll have to wait for my next column, in two weeks.

Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.

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