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ETF unfinished business in 2014: Crushing the mutual fund

For the fourth year in a row, I am attending the IndexUniverse Inside ETFs conference in Hollywood, Fla.

I've written for years about the advantages of exchange traded funds (ETFs): transparency, low cost, tax efficiency, intraday trading and the ability to easily diversify a portfolio into international stocks and bonds as well as commodities.

I have nothing against the mutual fund industry: Many funds are run by terrific managers that provide plenty of long-term value. And many fund families—Vanguard being the prime example—have long offered low-cost funds tied to traditional index funds.

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The literature clearly supports the idea that indexing is the way to go for most investors. And because of that, many mutual funds have fees that are way too high for the returns they provide. They've gotten away with this because most investors are fairly passive and because they have lacked alternatives.

(Read more: ETFs 2014: In with the unusual)

That's why ETFs are important. They are based on the concept that most fund managers do not beat their indexes (such as the S&P 500) over even moderate periods of time. By tying an ETF to an index, costs are greatly reduced.

An active debate
What about actively managed funds, where a stock picker tries to outperform the markets? My hat is off to the small group of fund managers who can do this successfully over many years, but the group is very small. Let's face it: The index vs. active management game was settled some time ago. On an annual basis, almost 60 percent of large-cap funds underperform the S&P 500, according to Deborah Fuhr of ETF research and consulting company etfgi.com. So you are paying considerably more for active management, only to have most fund managers underperform.

How much more? Actively managed funds typically charge fees of 1 to 2 percent; the fee for the SPDR S&P 500 ETF (NYSE ARCA:SPY), which tracks the S&P 500, is 0.09 percent.

Think about that. Even at the low end, a typical actively managed fund charges about 1 percent vs. 0.09 percent. That is one-tenth the cost.

The lower costs even extend to commissions. Many companies (Schwab, for example) offer commission-free trading on their own ETFs and select ETFs from other fund families.

The ETF industry has attracted three types of investors: 1) professional or semi-professional traders who trade the markets on a daily basis using ETFs; 2) active, self-directed investors who manage their own portfolios but do not trade on a daily basis; and 3) a small but growing group of investment advisors.

(Read more: Staying on the retirement track with ETFs)

In 2002, when I first mentioned ETFs, there was a mere $100 billion under management. By 2006 it had gone to $400 billion. By 2009 it had doubled, to $800 billion. Four years later, at the end of 2013, it had more than doubled again, to $1.7 trillion. And that's just in the U.S. These are small numbers compared to the roughly $14.8 trillion in stock and bond mutual funds, but the gap is slowly narrowing.

The ETF-enlightened advisor
Why aren't more investors looking into ETFs?

Two reasons: 1) the public's lack of interest in investing in general following the 2008 financial crisis, and 2) the inertia of the investment industry, which has armies of advisors built around the higher fee structures of the mutual fund industry.

But that is starting to change. At the Inside ETFs conference, there are about 1,500 small, independent registered investment advisors (RIA), many of whom now use ETFs partly or exclusively to invest their client's money. While many investment advisors will typically charge a 1 percent fee, many of the independent RIAs charge less, 0.5 to 0.8 percent, because of the relative ease and lower cost of managing portfolios of ETFs vs. traditional mutual fund-type products. The biggest growth in the last five years has come from investment advisors. They realized that they can still charge a reasonable fee of, say, 0.5 percent when they are in ETFs that only have 0.1 percent fees!

Bottom line: There is plenty of room for growth in the ETF industry, and there are two pieces of "unfinished business" for ETFs in 2014 in particular.

1. Make inroads into the 401(k) market.
Charles Schwab has promised for several years that they are on the verge of cracking this nut, but 2014 may be the year it's finally accomplished. One key will be to provide a reasonably wide sampling of ETFs and not just a single ETF family. In interviews, Schwab representatives have said they plan to offer more than 100 ETFs.

2. The debut of large-scale actively managed ETFs.
Only 4 percent of ETF assets are actively managed—4 percent! The only notable actively managed ETF in existence is the Pimco Total Return ETF (NYSE ARCA:BOND) run by Pimco bond guru Bill Gross. It's been a phenomenal success, though it saw outflows last year. The main problem for active management ETFs: Will they be transparent? Active managers who run an ETF would be required to disclose their positions on a daily basis, which most don't want to do. There is a proposal at the SEC to allow for "blinded portfolios," which do not require fund managers to disclose their positions every day. The industry is still waiting for the SEC to approve this type of structure.

By CNBC's Bob Pisani. Follow him on Twitter @BobPisani

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

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