If there's a single investing vehicle that has come a long way, it's the exchange-traded fund.
ETFs turn 20 this year with the anniversary of what is widely regarded as the first of its kind -- the now-ubiquitous SPDR Standard & Poor's 500 fund -- which traces the index by the same name and is in countless investor portfolios.
While index funds weren't an entirely new concept at the release of what is known in the market as the "spider" or "spyder," the design of ETFs sparked a $1.4 trillion revolution - the total assets under management for the funds.
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"What we're seeing now is a migration by investors, certainly institutions and even moving down into the mom-and-pop retailer who are looking at asset allocation to drive performance rather than manager selection," said Adam Patti, CEO at of IndexIQ Advisors. "If that idea holds, that means a lot more hope for the ETF market because ETFs are ideal asset allocation tools."
Sure, the ETF as an industry still doesn't measure up to its competitor, the $9 trillion mutual fund market, in terms of size.
But the new kid on the block is gaining ground all the time. Investors like ETFs because they are can be traded like stocks and have much lower fees than mutual funds.
"ETF penetration in retail is still quite low," Patti said. "But it's growing quickly and there's still a lot of space to grow in terms of wallet."
The funds have become not just an interesting story, but also a microcosm of the broader market itself, accurately reflecting investor sentiment in ways that polls and surveys cannot.
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In the risk-off nature of markets that dominated 2012 fixed income, ETFs were the biggest recipients of fresh cash, pulling in nearly $240 million for the year, outpacing large-cap equity, which generated $227 million. Commodities and international markets also saw large inflows as investors looked for choices outside basic U.S. stocks.
"Instead of just trying to beat the benchmark, you can be the benchmark," said Todd Rosenbluth at S&P Capital IQ. "There's a lot of ETFs that give you the flexibility to choose sectors or styles or countries, and newer ETFs are slicing into that even more so."
Indeed, one of the drawbacks of the funds is that they are perhaps getting too particular, offering investors leveraged funds to bet against certain indexes and asset classes. The so-called bear funds, though, can be hard to explain to investors and even harder to entice them to play.
"A number of ETFs have launched in the last three, four years are not as easy to follow and understand," Rosenbluth said. "Investors are moving into international equity and not fully understanding what is tied to what respective country."
The trend from plain-vanilla funds is likely to continue.
Patti envisions a future in which ETFs venture more into alternative investments, and the industry is seeking what he calls the "Holy Grail" of finally getting into 401(k) retirement plans, a space that thus far has been reserved for mutual funds and the firms that manage them.
Rosenbluth thinks fixed income funds will become even more popular in the difficult investment environment where volatility is high and safety remains a priority, though he advises most people to stay away from the funds that bet against the stock market outright.
"Investor education is needed," he said. "Many people are taking on this risk and they have forgotten how the ETF flows respond in a down market. It's going to be interesting."
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