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There is something vaguely unsettling about the explosive growth of exchange-traded funds and the passive investing strategies they employ.
It might be a sense of nostalgia: We are witnessing the twilight of stock- and bond-picking fund managers who get paid to beat the market. Or it might be a fear that the giant herds of investors now passively following securities indexes have created a momentum that will take us all over unknown cliffs in the future.
It's clear, however, that ETFs are the investment vehicle of choice for a wide range of institutional and individual investors. Introduced 30 years ago, ETFs now manage roughly $4 trillion in assets globally — still less than the amount invested in open-end mutual funds (actively managed and indexed) — but most market observers expect assets in ETFs to surpass mutual funds within a few years, based on current investing trends.
"It's a cost and diversification story," said Jim Rowley, a senior strategist in Vanguard's Investment Strategy Group. "You can get extremely broad diversification at extremely low cost with ETFs."
The advantages of ETFs — low cost, tax efficiency, intraday trading and an increasingly broad selection of products — seemed to make less of an impression on fixed-income investors. The migration of assets from actively managed funds into passively managed ones has been far slower in the bond markets than in equities. It is happening, however, and appears to be picking up steam.
Last year passively managed bond ETFs took in $148 billion, compared to $46 billion for actively managed bond funds. This year both actively and passively managed bond funds are raking in assets, with inflows of $144 billion to passive and $118 billion to active through the end of August, according to research firm Morningstar.
The low cost of ETFs is looking all the more attractive, given the extremely low yields on investment-grade bonds in most developed countries.
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"People are shifting actively managed assets into passive vehicles across most markets," said Alex Bryan, a senior nalyst with Morningstar. "The fixed-income market may be a little further behind the [equity] curve, but it's still following the same trend."
Fee-based financial advisors, early adopters of ETFs for equity exposure, also appear to be warming up to the funds for fixed-income investing. The most recent survey of more than 300 financial advisors by the Financial Planning Association found that ETFs were now the favorite investment vehicle of advisors, 88 percent, versus 80 percent for mutual funds.
Half of the respondents said they planned to increase their use of ETFs in the next year compared to just 20 percent who planned to use more mutual funds.
"I think there's still enormous room for growth in the use of ETFs by advisors," said Dave Yeske, managing director of registered investment advisory shop Yeske Buie.
Yeske, who is a certified financial planner, worked on the survey.
"ETFs are in everyone's toolkits now, and it's only a question of whether advisors will use them more. I think they will," he said.
While the survey didn't tease out numbers on the use of fixed income ETFs, Yeske says it stands to reason that advisors are using them more. For one thing, the proportion of advisors who said they invested in individual bonds fell to 52 percent, and only 16 percent said they planned to increase their investments in them in the coming year.
"Managing a bond portfolio is tough and the percentage of advisors doing it continues to fall," Yeske said.
Advisors still have concerns about investing in bond indexes. In the equity markets, the indexes that ETFs track are typically weighted by the market capitalization of the constituents. In the bond world, that means that the greatest weights in the index go to the companies with the most amount of debt — probably not a strategy that most advisors would embrace on their own.
Take the high-yield bond market, for example.
"We're not fans of passive index investing for fixed income," said CFP Barry Glassman. He said his firm has always maintained a position in the high-yield bond market, but has never used index funds — whether mutual funds or ETFs — because of the weighting issue.
"In 2014–15, the index became heavier and heavier with energy bonds as exploration companies and frackers issued more and more debt," he said. "You end up being invested in the most indebted companies."
Similarly, ETFs such as the fund end up with U.S. Treasuries and Agency mortgage-backed securities, making up more than 60 percent of the portfolio because of the vast amounts of such debt outstanding. In the total international market, you get heavy weightings in the low-yield markets of Japan and Germany.
If the weightings in broad-based indexes aren't what you want, however, there are plenty of other options. There are now thousands of ETFs tracking indexes of companies in specific industries and geographic markets, as well as a huge variety of factors.
So-called smart beta funds that determine index weightings based on factors such as volatility, dividend yield and fundamental performance rather than just market cap have been around for years in the equity markets. They are now making headway in the fixed-income space.
"We're seeing the smart-beta concept play out in the fixed-income market now," said Ryan Sullivan, vice president of global ETF services at Brown Brothers Harriman. "We're seeing funds with indexes weighted according to credit quality or duration or yield."
Sullivan helps fund companies design and market new ETF offerings and expects the pace of innovation — almost all on the ETF side of the fund business — to continue for some time.
Does the craze for ETFs represent a new source of risk for the market? Yeske doesn't think so.
"I haven't seen any research suggesting market valuations are being driven by the growth of ETFs," he said. "They are just an alternative vehicle for people to get into the markets."
He also thinks that in a 2008-like crisis where panic selling leads to more selling, ETFs won't be adding fuel to the fire. While mutual funds have to sell securities to meet shareholder redemptions, ETFs are bought and sold by investors with each other not with the fund.
"I think ETFs would probably be a force for stability more than anything else," said Yeske.
— By Andrew Osterland, special to CNBC.com