On Wall Street, if a little of something is good, then a lot of it must be magnificent. How else to explain the proliferation of exchange-traded funds (ETFs)? From the launch of the first in 1993 (to duplicate the performance of the S&P 500 index), the number of ETFs has surged to 542 at the end of June. Indeed, 162 new ETFs have been launched in the first 6 months of this year. In true Wall Street style, that’s one a day, reserving Sunday to worship Mammon.

    Piles more are on the way.

    You can get an idea of how quickly ETFs have grown by comparing their growth to traditional mutual funds and to index funds:

    Mutual funds. The first mutual fund, MFS Massachusetts Investors Trust, was created in 1924, but even the Roaring ‘20s didn’t get the number of mutual funds over 10 in the first five years. It took an incredible 56 years before the number of mutual funds reached the 542 that ETFs have reached in only 14 years.

    Index funds. While the first index fund was actually created in 1960 (Vanguard Small Cap Index), most of us think of 1976 as the beginning of index funds. That’s when Vanguard introduced the original Vanguard 500 Index fund. Three years later there were only 3 index funds. Ten years later there were only 13. It took 25 years--- until 2001--- before index funds numbered what ETFs number today at 14 years.

The ETF Fast Track
This table compares the development of mutual funds, index mutual funds and exchange-traded funds.
  ETFs Index mutual funds Mutual funds
Year of first fund 1993 1976 1924
Number at 3 years 2 3 4
Number at 5 years 20 4 10
Number at 10 years 124 13 38
Number at 15 years Na 47 63
Number today 542 1255 24155
Years to 542 14 (2007) 25 (2001) 56 (1980)
Sources: Morningstar, Investment Company Institute


    ETFs, obviously, are on a rocket ride as multiple sponsors push the envelope of possible indexes, expand the number of fixed income offerings and reach toward creating managed ETFs. In the process, the once clear waters of a limited index fund spring have turned into a gushing sewer pipe of speculative products. The common theme of many of the new ETFs is that they chase increasingly obscure market segments at rising fees. That’s great for Wall Street, lousy for investors.

    Fortunately, investors appear to be a good deal smarter than the marketers. If you examine the distribution of net assets in the ETF universe, you’ll find that hundreds have failed, so far, to attract enough assets to make them efficient investment vehicles. Unless an ETF has a large asset base and is actively traded, most investors are likely to be better off buying a comparable index mutual fund.

    While the top 54 of all ETFs have gathered significant assets--- at least $2.1 billion--- the multitudes at the bottom may soon be history if they don’t start bulking up with assets soon. The 108 ETFs in the bottom 20 percent of assets, for instance, have $11.5 million or less, according to Morningstar. In addition, 225 ETFs have less than $50 million in assets, and 284 have less than $100 million. 

    Does that mean ETFs have gone from being a good thing to a bad thing?

    I don’t think so. It just means we have to ignore a lot of Wall Street garbage and concentrate on the ETFs that are genuinely useful. One easy example, outlined in this column, is that ETFs can be useful for workers stuck in lame 401(k) plans with expensive choices--- but that offer a “brokerage window.” Provided the account is large enough and the brokerage commissions are small enough, the brokerage window allows you to establish a very inexpensive, diversified index portfolio.
    So which ETFs qualify as genuinely useful to the average investor?
    Here’s my short list, by broad asset category. What they have in common is that they are already relatively large, cover an actual asset class and have low expense ratios.

  • Domestic Large Cap: Vanguard Total Stock Market  (ticker: VTI, Expense Ratio: 0.07 percent)
  • Domestic Small Cap: Vanguard Small Cap ( ticker: VB, ER: 0.10 percent)
  • International: iShares MSCI EAFE ( ticker: EFA, ER: 0.35 percent)
  • Emerging markets: Vanguard Emerging Markets (ticker: VWO, ER: 0.30 percent)
  • REITs: Vanguard REIT index (ticker: VNQ, ER: 0.12 percent)
  • Inflation Protected Securities: iShares Lehman TIPS (ticker: TIP, ER: 0.20 percent)
  • Short Term Treasurys:  iShares Lehman 1-3 Treasury (ticker: SHY, ER: 0.15 percent)


    Are there others?

    You bet. Those who seek greater diversification would do well to add value indexes for large cap, small cap and international. Another I’ve written about is the Powershares FTSI RAFI 1000 (ticker: PRF, ER: 0.76 percent). Based on a concept of fundamental rather than market capitalization indexing, this fund offers an interesting (if expensive) challenge to traditional indexing.
    Hundreds of other ETFs are just baskets of stocks to buy and sell for speculation--- but that’s not investing.

 

 

On the web:

 

Sunday, October 28, 2006: Practical ETF Investing--- the Online Calculator

Sunday, September 30, 2003: The Economics of the Fidelity 401(k) Brokerage Window

 

Sunday, September 12, 2006: The 401(k) Brokerage Window Revisited


Sunday, November 11, 2006: The Looming Battle: Fundamental vs. Traditional Indexing