Why ETFs Are the Most Important Development for Investors in Decades

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I'll be at the IndexUniverse Inside ETF Conference all day Monday and Tuesday.

Exchange-traded funds (ETFs) are the most important development for investors — and the fund industry — in decades.

I mean it. I'm a big backer of ETFs, for many obvious reasons.

For one: diversification of your portfolio. Think about this: Prior to 2004, there was no way easy way to own gold. Sure, you could buy coins or open a futures trading account, but they were clumsy vehicles. The SPDR Gold Trust (GLD) changed all that.

You couldn't own oil either. Or natural gas. Or stocks in Tokyo very easily. And certainly not Asian bond funds. Heavens.

Now you can ... using ETFs.

And the investing public has responded.

The ETF business has grown exponentially in the past decade. 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.

Three years later, at the end of 2012, it hit $1.3 trillion, a 25 percent increase in one year.

That's just in the U.S. If you include the rest of the world, ETFs broke through the $2 trillion mark at the end of January for the first time, according to etfgi.com.

These are small numbers compared to the roughly $13 trillion in stock and bond mutual funds, but trust me, ETFs are gaining fast, and the mutual fund industry is staring nervously over its shoulder. Some — like Vanguard Group — have long since joined the ETF ranks.

Even more importantly: The ETF industry has attracted the biggest, and best, players. Players with deep pockets, particularly the ones at the very top.

It's an industry that is very top heavy. Three ETF providers — Blackrock/iShares, State Street, and Vanguard — control more than 80 percent of the assets under management.

Does that bother me? Normally, I would prefer more diversification, but these three are top notch, and the remaining 20 percent fill different niches, from inverse/leveraged ETFs to exotic international instruments.

Why the growing interest in ETFs? Besides diversification, ETFs provide lower costs, better portfolio transparency, and they are more tax efficient than most mutual funds. For active traders, the ability to trade during the day is the clincher.

But those are the most obvious reasons — there's an even bigger reason I'm an ETF supporter.

For most investors, indexing is the way to go. According to fund analyst Deborah Fuhr, 81.2 percent of active large-cap managers in 2011 didn't beat the S&P 500.

Think about that. Mutual fund investors pay exorbitant fees — usually one to two percent a year, or more — for active management. And most do not outperform benchmark indexes.

No wonder many younger, innovative, cost-sensitive financial advisors have adopted ETF portfolios. Instead of charging, say, a one percent to two percent fee each year, financial advisors can charge, say, 0.5 percent, and put their clients in an internationally diversified portfolio.

Ah, but they are just tied to indexes, you say. So what? There are ETFs that now operate across all asset classes (stocks, bonds, commodities, real estate) and across dozens of countries.

My point: Financial advisors can now generate their own "alpha" (outperformance) by placing their clients in the right ETFs.

Or you can do it yourself — generate your own "alpha." You can be an active manager using ETFs.

What's going to happen in 2013? That will be the big topic at this conference, but here's a few thoughts of my own:

1) Fare wars will continue, and the consumer will benefit. Last week, Charles Schwab introduced a new trading platform with commission free trading for its 15 ETFs and 90 other ETFs.

Besides commissions, there is also a separate war being waged around expense ratios, which are also dropping. Schwab for example charges only 0.04 percent for its U.S. Broad Market ETF (SCHB) ... that is amazing (40 cents per $1,000!), considering many mutual funds charge a full one percent. The biggest ETF, the iShares S&P 500 (SPY), charges 0.09 percent, but others charge much more. They will come under pressure from competitors.

2) A major ETF company will announce a deal to provide ETFs to 401(k) plans. This is the holy grail for ETFs and will be the lever by which ETFs finally provide serious competition to mutual funds. My bet: It will be Schwab.

3) Several actively managed ETFs will enter the marketplace. And they may come from new sources, like Legg Mason and T. Rowe Price. The only notable actively managed ETF in existence is Bill Gross' Pimco Total Return (Bond), which has been phenomenally successful. The Securities and Exchange Commission has lifted a moratorium on the use of derivatives by actively managed ETFs under some circumstances, so we should see more of them. But will they be transparent?Active managers do not like having their positions revealed; the hallmark of ETFs is, everyone knows what your position is. Expect a fight over this.

4) More closures of ETFs ... the number of ETFs that closed spiked in 2012 to nearly 100, but there will be more. There are 1,400 ETFs in the U.S., but most are tiny--too tiny to make a profit. The top 10 ETFs have 36% of all the assets under management. Regardless: other ETFs will be created as funds create "copy-cat" products that attract enough money to justify their existence. There will also be more exotic products introduced.

I want to hear from you. What do you think will be the hottest ETF asset class this year? Tweet @BobPisani with #InsideETFs.

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.

  • Bob Pisani

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


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