Forget Stocks: Investors Pile Into Exchange-Traded Funds

Investors are funneling more and more money into exchange-traded funds to brace against what is expected to be a difficult market in the coming months.

Traders at the New York Stock Exchange.
Photo: Oliver Quillia for
Traders at the New York Stock Exchange.

Concerns about both volatility and a sideways churn after a massive seven-month rally have steered investors away from direct stock plays and into ETFs so they can be nimble while still investing in broad sector indexes.

Unlike regular mutual funds, which are priced once a day after the market close, ETFs trade throughout the day just like stocks.

September saw the ETF industry surpass $700 billion in funds under management—a new high—as investors flocked to the vehicles and away from hedge funds and other risky instruments.

"Individual investors are buying more and more open-end funds and they're buying more and more ETFs," says Keith Springer, president of Capital Financial Advisor Services in Sacramento, Calif. "You have the appearance of diversification and professional management; you don't have to pick individual stocks. They're liquid and it's much cheaper."

Interestingly, it's not even the ETFs that hold individual stocks that are driving the surge.

Fixed-income funds, particularly taxable bonds, were the big gainers in the third quarter and throughout 2009. The group has seen an inflow of $26.7 billion this year, including $8.1 billion in the third-quarter alone, according to data from Morningstar.

Conversely, US stock ETFs have seen a net outflow of $30.4 billion in 2009.

"Over the last quarter the influx (in bond funds) has been there and we're still seeing unprecedented highs in the amount of money in these things," says Bill Walsh, president of Hennion & Walsh in Parsippany, N.J. "There's a little bit more dependability than the equity market. They still feel the volatility and uncertainty of equities."

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The iShares Barclays TIPS Bond ETF has been the big winner in the group, more than doubling its assets in 2009, Morningstar said in a recent analysis.

Other leaders this year in asset generation are the iShares iBoxx $ Investment Grade Corporate Bond, SPDR Barclays Capital High Yield Bond and the iShares iBoxx $ High Yield Corporate Bond.

At the same time, ETFs that play the broad indexes are still the most popular in trading volume among investors on an individual basis, despite the recent trends.

The SPDR Trust , which is indexed to the Standard & Poor's 500, by far remains the leader in volume, with an average of 194 million shares a day changing hands. The PowerShares QQQ , which tracks the Nasdaq tech barometer, is second.

But four of the top 10 ETFs are bear funds, meaning that investors remain heavily interested in capitalizing on downward moves in the market. The Direxion Daily Financial Bear , which provides three times the negative of movements in the Russell 1000 Financial Index, sees average daily volume of nearly 74 million shares.

Though those types of bear funds have received their share of criticism, investment advisors generally like the diversity of options the ETFs provide.

A trader at the New York Stock Exchange.
Photo: Oliver Quillia for
A trader at the New York Stock Exchange.

"The ETF community generally has been very creative in making sure they introduce products that capture investors' attention," says Nicholas Colas, chief market strategist at ConvergEx, an institutional brokerage in New York. "The ETF world is definitely taking a page out of the mutual fund playbook. They're coming up with all kinds of varying products. With ETFs, every day is a new day."

That's important to Colas, who believes the market has reached a fair value point after hitting a middle ground between the October 2007 historic highs and the lows of March 2009.

He's not especially bearish, but believes that investors looking to capitalize on a market moving in a tight range need to spot a handful of trends that will make money.

In a recent research note, Colas broke the trends into three categories and provided possible ETFs for each move, primarily as hedging mechanisms:

  • Consumer weakness: Slow holiday spending will weigh on the economy, so he recommends the ProShares UltraShort S&P 500 , which bets double against the S&P. He also says industrial sector ETFs could work as a hedge against the consumer.
  • Further Dollar Weakening: There are a variety of ways to play hedges on the dollar, which is likely to stay low as the economy struggles to recover. The PowerShares DB Dollar Index Bearish is a direct play, while the SPDR Gold Shares and Claymore/Beacon Global Timber Index are both long funds that bet on goods which prosper during US currency weakness.
  • Geopolitical turmoil: Should situations in Iran or Pakistan escalate, investors will want to play oil, which can be accomplished through the PowerShares DB Oil Fund . "A strong geopolitical shot will hurt financial asset values," he says. "Good diversification tells you that you should find an asset that will rise on that."

Capital Financial's Springer also has doubts about a robust recovery and is adjusting client portfolios for gains he sees in mid-cap stocks, utilities and emerging markets. Respectively, he is using the iShares S&P MidCap Growth Index, iShares DowJones US Utilities and Direxion Daily Emerging Markets Bull 3X Shares that pays triple on growth in the MSCI Emerging Markets Index.

Most of the index funds are passively managed. However, the market is beginning to see more active managers into ETFs, with big mutual fund names such as Vanguard, PowerShares and State Street gaining a foothold.

Indeed, the popularity of ETFs has seen some mutual funds comprised solely of ETFs. One such fund is the four-star ETF Market Opportunity Fund , which holds a mixed bag of ETFs with the PowerShares QQQ as its largest component.

"Investors want exposure to ETFs but when they look there's over 800 between the ETNs and ETFs themselves. They kind of get lost," says Paul Frank, portfolio manager of ETFOX. "What I try to do is give them a prepackaged product."

Frank doubts whether the active funds will catch on, but they appear to be gaining popularity among investors tired of hedge funds and their unpredictability.

Barclays Wealth is one such institution trying to lure wealthy hedge fund investors, pushing the simplicity and liquidity of ETFs as a healthy alternative to the dangers of the hedge world.

"There are a lot more ETFs in different asset classes than (there) had been in the past, and they're becoming more nuanced," Sean Crawford, portfolio manager of the new strategy at Barclays, told Reuters recently. "It's become a pretty compelling investment idea."