Trading, Investing Or Both?

January 08, 2009

Jim's picking a fight in his last blog. And I'll take the bait.

I know he's picking a fight because he has mischaracterized what I wrote in my last blog. Nowhere do I say, as Jim (incredibly enough) puts in quotes, that "ETFs are all about the sensible, long-term-focused, asset allocation advisor."

That's absurd. I spent a good part of 2008 writing about the issues of spreads, liquidity and ETF trading. The single most important article I wrote last year was one that questioned the real driving factors behind bid/ask spreads in ETFs. I'm proud to say that that article touched off a national discussion on ETF spreads, and changed the way liquidity is discussed in the ETF space.

Here's what I actually wrote Wednesday:

"2008 was the biggest year ever for ETF inflows. Investors poured more than $178 billion in new money into ETFs, according to the NSX. For comparison, Emerging Portfolio Funds Research says that investors pulled $320 billion out of mutual funds in 2008."

The mutual fund data is just for comparison, as noted. Nowhere do I imply that investors took money out of mutual funds and put it to work in ETFs. But Jim has been itching to get into an argument about what's driving growth in the ETF industry, so here we are.

The Growth Of ETFs

For starters, there is no question that the majority of inflows into ETFs in 2008 came from the trading community. The rise of trading was the single biggest ETF story in 2008, and the numbers are incredible.

But there is equally no question that some of the growth has come from investors and advisors embracing ETFs in great numbers. BGI, State Street and PowerShares don't spend their millions advertising and educating this audience for fun.

What's more, if you look at the actual data, you'll see strong evidence that at least in some places, investors are moving in.

Consider Vanguard and ProShares. They represent two completely separate sides of the ETF equation.

Vanguard's ETFs are great products that are marketed almost exclusively to financial advisors. They have ultralow expense ratios, and make great sense for buy-and-hold investors.

They may not, however, be the best funds for traders. A trader doesn't really care that the Vanguard MSCI indexes have slightly more complete exposure than the Select Sector SPDR ETFs. What people care about is that the Select Sector SPDR ETFs trade at one-penny spreads, whereas the Vanguard sector ETFs often trade 3-5 cents wide. So let's assume that the bulk of assets flowing into the Vanguard ETFs were "investments."

ProShares, on the other hand, is all about trading. The ProShares leveraged and inverse products don't really work as long-term holdings, as the issue of compounding means that the returns you will receive are uncertain.

A lot has been made of ProShares' impressive inflows in 2008, and rightfully so: The company pulled in $20.4 billion in new assets. But Vanguard actually had larger inflows-$25.6 billion.

A New-Money Phenomenon

I'm not suggesting that the bulk of money flowing into ETFs in 2008 came from investors bent on asset allocation. But 19 of 21 ETF fund families had positive cash inflows in 2008: The only exceptions were Rydex and XShares. Some of that money is invested assets. And five years ago, some of that money would have ended up in mutual funds. There is just no question about that.



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