Exchange-traded funds: Trillion-dollar babies

Interesting article from the Economist of the fast-growing ETF industry.  ETF AUM has recently crossed the $1 trillion mark with nearly 2000 list funds worldwide.  The growth in ETFs has been nothing less than spectacular.  However, we do share some of the worries presented in the article:

First, new launches are focusing on specialised asset classes. In the latest example, Marshall Wace, a hedge fund, is launching its own ETF. The total costs on such funds are higher than on those tracking broad indices like the S&P 500, undermining the model’s low-cost rationale.

Second, although specialised funds are very useful for professional investors, they may tempt retail investors into taking too much risk. Emerging markets and commodities were among the fastest-growing ETF types in 2009. The biggest gold ETF, run by State Street, now has a higher market value than Barrick, the world’s biggest gold miner. Some blame the rapid growth of gold ETFs for pushing the bullion price to record peaks in late 2009.

Third, because it is easy for private investors to buy and sell ETFs, they may be tempted to trade them too often. This will erode their cost advantage, since every transaction involves a fee. Trading activity was down by 38% last year, at $50 billion a day. But if markets keep rising, ETFs may be to the next generation of day-traders what dotcom stocks were in the late 1990s.

However, most of the specialized funds still have lower fees than the majority of Mutual Funds, Hedge Funds, etc.  Take a fund like VXX (iPath S&P 500 VIX Short-Term Futures ETN), while the .89% fee is not insignificant, it is much lowever than the typical 1-2% of Specialzed Mutual Funds, and Hedge Funds.   We believe the portfolio hedging capablilites that funds like VXX provide, outweigh a slightly higher cost.  Frankly, before the boom of asset class specialized ETFs, most investors had to rely on pricey Asset Managers to provide such hedging capabilites.  ETFs have blown that door wide open and have given investors powerful tools to allocate asset, hedge and speculate like the pros. 

In regards to risk, investors can always find it no matter what.  Margin accoutns and options have long given the individual investor access to high amounts of leverage.  The 2x/3x ETFs might provide a little more ease in doing so, but certainly are not creating anything new.

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