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ETF Assets Could Hit $1 Trillion By 2011

Assets in exchange-traded funds surged to a record $906 billion in September, following a large influx of investors into State Street’s ETF that tracks the S&P 500 Index, according to the latest data from Birinyi Associates. ETF flows last month totaled $27 billion, putting the industry on pace to reach $987 billion in assets by the end of the year and maybe more if an equity rally continues to draw in more participants.

“The ETF has killed the mutual fund,” said Jim Iuorio, a trader with TJM Institutional Services. “I wouldn’t think of using a mutual fund to get broad exposure to the market, when you can do it in a more liquid and cheaper way with ETFs.”

The S&P 500 jumped almost 9 percent in September for its best gain in the normally gloomy month since 1939. More than $10 billion flowed into the SPDR S&P 500 , according to Birinyi. The inflow into all ETFs – emerging market, bond, currency, etc. -- was the most since December 2008.

Except for a slight slip in assets following the credit crisis, money in ETFs has steadily grown every year since their creation. To the detriment of mutual funds, interest in these funds, which track whole markets and sectors like they are individual stocks, have only increased over the last two years as a burned public look to take investing into their own hands. Besides their liquidity and lower cost structure, ETFs also allow investors to bet against asset classes, something that only savvy hedge funds could do at one time.

Meanwhile, investors have yanked $18 billion from equity mutual funds this year, according to August data from the Investment Company Institute. Total assets in the country’s mutual funds are still more than $10 trillion, according to ICI.

To be sure, ETFs have no shortage of critics, who argue that they are just the next bubble for Wall Street to inflate before clients are left holding the bag. ETFs played a hand in the ‘Flash Crash’ on May 6, when the Dow lost nearly 1,000 points in minutes, by allowing so many stocks to be sold at such a quick pace, according to the SEC’s report released last week.

Some have gone so far to say that these funds could actually blow up. ETFs have a much more complex structure than just a simple basket of stocks. They are actually made up of so-called “creation units,” which represent a certain number of shares of stock.Investment firm Bogan Associates put out a notable report last month that examined this fractional ownership make-up and how it could lead to a potential market event.

“Like many innovations in finance that emerge from nowhere to explode in popularity with unknown consequences, exchange-traded funds have gone from obscurity when they were first invented in 1993 to making up more than half of all the daily trading volume on American stock exchanges today,” state the report by a team led by Dr. Andrew Bogan. “They also made up 70 percent of all the canceled trades during the Flash Crash on May 6, despite representing just 11 percent of listed securities in the United States, suggesting that ETFs remain poorly understood by both investors and regulators.”

The popularity of ETFs may also aid in the inflation of bubbles as mutual fund managers try to chase the gains of their benchmark, taking on more risk than they would without their existence. Over the last 15 years, mutual fund managers are keeping less and less cash on hand because of the fear of losing to the always-invested ETFs, according to Alan Newman, editor of the Crosscurrents newsletter and an early critic of the instruments.

With mutual fund managers essentially staying fully invested at all times, good and bad, “increased risk exposure is now at best, a lesser consideration than before and at worst, is not considered at all,” wrote Newman, in his latest monthly report. “Indexed funds are not ‘managed’ per se, but only exist as a proxy. Thus, there is zero discretion to avoid stocks when prices are out of whack with the fundamentals.”

It’s this second-hand effect that may in fact be the biggest risk to this system.

For the best market insight, catch 'Fast Money' each night at 5pm ET, and the ‘Halftime Report’ each afternoon at 12:30 ET on CNBC.

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Trader disclosure: On Oct. 6, 2010, the following stocks and commodities mentioned or intended to be mentioned on CNBC’s Fast Money were owned by the Fast Money traders; Guy Adami owns (AGU), (INTC), (BTU), (NUE), (C), (GS) and (MSFT); Tim Seymour is long (AA), (AAPL), (BBY) and (MON); Karen Finerman's firm is short (MDY); Karen Finerman's firm is short (SPY); Karen Finerman's firm is short (IWM); Karen Finerman's firm is short (IJR); Karen Finerman's firm is long Russell 2000 Puts; Karen Finerman's firm is long S&P 500 Puts

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