Funds and ETFs

ETF Surge in 2012: 'They Are Here to Conquer'

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Investors were an unpredictable lot during 2012, but they at least were consistent in their preferred mode of action.

Exchange-traded funds took in a record amount of new money during the year, surpassing 2008 and sending total assets under management to $1.34 trillion, according to sources that track the industry.

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 are closing 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 $282.6 billion, or 26 percent, increase this year in assets, 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 towards passive investing as opposed to active. Market correlations - or all assets moving together up and down - have made diversification difficult and indexing an easy way to limit volatility and still capture the 12 percent market gains this year.

"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 and certainly has continued into 2012."

Though some are actively managed, most ETFs track indexes such as the 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 this year has 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.

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."