Exchange traded funds hit milestone in 2004

NEW YORK -- It wasn't a bad year for conventional mutual funds, but exchange traded funds experienced dramatic growth in 2004, raking in an unprecedented amount of new cash.

Interest in ETFs -- passive investments that track indexes but can be traded like stocks -- has risen steadily since they were introduced more than a decade ago. Equity ETFs closed December with a record-setting full-year inflow of $54.4 billion, according to preliminary data from TrimTabs Investment Research Inc., which tracks fund flow data for institutional investors.

That far outpaced ETF inflows for 2003, which came to just $15.1 billion, according to the Investment Company Institute. The previous record was set in 2000, when ETFs collected $42.5 billion.

The ICI, the mutual fund industry's lobbying group, keeps the official tally of flows, but will not have final figures for 2004 until the end of January. TrimTabs, an independent service that tracks a significant segment of the fund market on a weekly basis, was within 3 percent accuracy of the ICI's year-to-date totals through November.

For conventional funds, preliminary data showed inflows of about $180.3 billion during 2004, TrimTabs said, including an estimated $11.4 billion in December. That's higher than 2003's inflows of $151.4 billion, but far short of the huge numbers seen in 2000, when conventional equity mutual funds collected $309.4 billion.

All in all, "2004 was not a particularly good year for conventional fund flows," said Carl Wittnebert, director of research at TrimTabs.

The fact that money flows into conventional mutual funds are substantially below 2000 levels while ETFs have hit a new record suggests the relative popularity of exchange traded funds is on the rise, Wittnebert said. "Given the tax advantages of ETFs, the only surprise is that it took so long," he added.

In general, index funds have much lower turnover -- meaning they buy and sell stocks less often -- than actively managed funds, which lowers the likelihood that they'll distribute capital gains. ETFs also charge sharply lower annual expenses compared to most mutual funds, even index funds.

"The No. 1 issue ETFs have over anything else is that these are passive investments, so they are lower cost," said Darwin K. Abrahamson, chief executive of Invest n Retire LLC in Portland, Ore., which uses ETFs to build portfolios. "The cost of any investment fees you have has a direct relationship to performance, and the lower you can cut the costs down, the higher you'll raise the investment performance, whether your investment is taxable or tax-free."

One of the problems small investors have with ETFs is that because they're traded like stocks, each time they buy more shares, they're charged a trading fee. For dollar-cost-averagers -- people who contribute to their investment on a regular basis -- this has made low-cost index mutual funds a more practical choice. But with many firms working to lower commissions, ETFs' trading costs are becoming less of an issue, Abrahamson and other experts said.

Given their relatively short history it may come as a surprise that ETFs actually offer more choices for investors who are looking to construct a diversified portfolio using a passive approach. Many of the major indexes that can be bought in the form of ETFs are not available through conventional mutual funds. The fact that there's such a wide variety of options, and there are no investment minimums, has caught the attention of financial advisers and long-term investors alike.

However, the oldest and biggest ETF remains the most popular. TrimTabs preliminary data shows the biggest gainer for 2004 was the Standard & Poor's Depositary Receipts, or SPYDERs ETF, which tracks the S&P 500; it pulled in $7.7 billion.

With 97 ETFs, iShares Funds has become a significant player since it was launched in 2000. The iShares Funds, marketed by Barclays Global Investors, drew in about $44 billion in new money during 2004, accounting for more than 80 percent of total equity ETF inflows for the year. Such brisk business has made it the third-fastest growing fund family, just behind American Funds and Vanguard Group.

There's no way to know exactly who's buying ETFs, but based on custody reports and information from brokerages that sell its products, Barclays estimates about 60 percent of iShares' 2004 business came from retail investors. When iShares first came to market, about 80 percent of its business was institutional, said J. Parsons, a managing director at Barclays. The shift shows that advisers are discovering ETFs can work well for buy-and-hold investors with smaller accounts.

"Institutions were quick to use ETFs, while retail was a slower educational process," Parsons said. "I can't say it's a good thing for all small investors ... but the good thing is the information is all there for you to make an informed purchase."