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ETFs Growing and Growing, and 'Here to Conquer'

Plesea Petre | E+ | Getty Images

Investor behavior can be highly unpredictable, but it's getting consistent in at least one regard.

More and more they're turning from managed funds and using indexes to express their sentiment about where the financial markets are heading.

Exchange-traded funds have started 2013 with a bang after taking in a record amount of new money the previous year.

(Read more: ETF Price Wars Keep Heating Up)

Total assets under management have zoomed to $1.43 trillion, with a stunning 5 percent growth in just the first month or so alone.

While ETFs remain well behind the $9 trillion or so that the competing mutual fund industry still holds, the gap is clearly narrowing.

"That U.S. listed exchange traded funds (closed) out 2012 with such strong asset gathering – at or near a very considerable record – does engender a whole range of questions over the future of capital markets and especially equities," Nicholas Colas, chief market strategist at CovergEx, said in an industry analysis. "The data is clear: ETFs aren't just here to stay; they are here to conquer."

Based on the new money that's come in over the past year or so, the industry could double every four or five years. At that rate, it could overtake mutual funds in about 12 years.

(Read More: Why Investors Are Dumping Stock Funds for ETFs)

There are a variety of reasons for the ETF growth.

Because they trade like stocks ETFs are easier to use than mutual funds, which can be bought or sold only outside of exchange hours. They also generally have lower fees attached.

More broadly, though, the popularity reflects a powerful trend toward passive investing as opposed to active. Market correlation - or all assets moving together up and down - has made diversification difficult and indexing an easy way to limit volatility and still capture the substantial gains the market has made.

"ETFs have certainly benefited from that trend, as the vast majority of ETFs are passively managed index products," Joel Dixon, senior investment strategist at Vanguard, said in an interview. "So it's the low-cost mantra that has worked very well over the last several years."

Though some are actively managed, most ETFs track indexes such as the Standard & Poor's 500 or individual sectors within the broader market indicators.

Actively managed mutual funds, whose composition changes according to investment goals, have performed poorly over the past several years compared to their benchmarks and have seen outflows as the exchange-traded products grow.

(Read More: Why the Days of Stock Picking May Be Coming to an End)

There are other, less obvious reasons.

Financial management is changing from collecting commissions to charging fees for handling portfolios, a trend that is suited for ETFs and their own low fee structure.

"There's been a fairly significant shift in financial advisory community over the course of the last several years away from traditional commission-based services that mutual funds were the centerpiece of to more fee-based platforms, where advisors are charging fees to manage the portfolio then using lower-cost options in the underlying investments," Dixon said.

That shift to ETFs undermines a popular marketplace mantra - that all the money coming from stock-based mutual funds is going either to bond funds or the money market. In fact, nearly half the $130 billion drained from equity mutual funds in 2012 made its way to similarly based ETFs.

(Read More: Bye-Bye Bonds? What Fund Flows Say About 2013)

"The capital invested in these products has been uniformly 'risk on,' with equity flows dominant – 60 percent for the year and fully 70 percent for the fourth quarter," Colas said.

There is one danger often cited about ETFs that likely will get more prevalent as the industry grows.

(Read more: Emerging Markets: The Big Story of 2013?)

Because they are easily traded, the funds are being used in some quarters as trading vehicles that mimic stocks, somewhat defeating the idea of passive management.

"If you have just substituted a traditional mutual fund with active management for a financial adviser who is using ETFs to tactically allocate into other countries or other sectors of the market...really what you have done is substituted one form of active management for another," Dixon said. "People just need to be aware of the different forms of active management."

He expects the broader ETF trend to continue, though, and said it actually has been positive for Vanguard even if the firm is often associated more with mutual funds.

"ETFs have really taken off in many ways over the course of the last several years," Dixon said. "We certainly would expect that to continue."

Tune in: CNBC is the exclusive broadcast partner of the 6th Annual Inside ETFs Conference. Be sure to catch On-Air Stocks Editor Bob Pisani ( @BobPisani) live from the conference throughout the day on Feb. 11th and 12th , only on CNBC.

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  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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