Is the Day of the ETF Upon Us?

Are ETFs on the verge of overtaking mutual funds as the middle-class, middle-American investment of choice? On the face of it, the answer is no: The mutual fund market commands about $10 trillion in assets right now, whereas the amount of assets in exchange-traded funds is closing in on just $1.4 trillion.

But all the momentum is on the side of the ETFs. One of the biggest market stories of the year is how much money has been flowing out of U.S. equity mutual funds. For the week ended August 22, domestic stock funds lost another $4.48 billion in assets, bringing the year-to-date total of outflows for these funds to a whopping $75 billion. While equity mutual funds were losing $200 billion in net outflows over the three years from 2009 to 2011, U.S. equity ETFs were taking in a total of $85 billion in net inflows. Overall, U.S. ETFs have been adding about $118 billion per year.

Yes, the trends are all in favor of ETFs. They have been adding about 2 percent in assets per month lately, according to a study from State Street Global Advisors.  There are more than 1,400 ETFs now being actively traded on U.S. markets, up from 350 funds in 2006. At the end of 2000, there was just $59 billion invested in ETFs, according to Morningstar data, which means that in little more than a decade, their assets have grown by 200,000 percent.

But even more than the raw numbers, the way in which ETFs have come to be used suggests that they are here for the long haul, and have a lot of growth left within them. ETFs have sometimes had the reputation of being for short-term traders, as opposed to mutual funds, which more often fall into the buy-and-hold category. But a new study from Vanguard has shed a little different light on that.

The majority of Vanguard customers’ trades in ETFs — 62 percent of them — were the result of strategic allocation decisions and were expected to be held for more than a year That’s less than the 83 percent of all mutual funds trades that fell into the same category, but it’s in the same ballpark.

Vanguard looked at what it calls “investment reversals” — the first buy after a sell or the first sell after a buy — for both mutual funds and ETFs, and found that they were very similar over the long term. About 95 percent of all ETF investments averaged fewer than four investment reversals per year, as opposed to 99 percent for mutual funds.

Moreover, Vanguard found that much of the difference in strategies between the two vehicles can be attributed to the fact that investors in ETFs tend to be heavier traders than those who buy mutual funds. Once the study controlled for previous behavior, it turned out that ETFs were used in buy-and-hold strategies nearly as much as mutual funds were.

“Our evidence suggests that we’re not seeing ETFs cause people to trade more frequently,” said the senior investment strategist for Vanguard, Joel Dickson, upon the release of the study. “Rather, what we’re finding is that people who trade more are choosing ETFs more frequently these days.”

ETFs have been invading the institutional space as well. From their beginnings, they were seen as the province of the little guy and the individual trader, but now institutional investors control 53 percent of the ETF assets out there, according to a study from Dow Jones Newswires. Financial advisors controlled 25 percent of the ETF market, while brokers controlled 20 percent.