ETFs Are Becoming More Popular Than Mutual Funds

A recent article on Morningstar has highlighted a very interesting trend - ETFs are attracting net inflows while mutual funds are experiencing substantial net outflows during the past few months and this year overall. It is not surprising that people are pulling money away from the actively managed mutual funds given that even some of the safest ones, money market mutual funds, can't avoid a negative return. Of course, then we also have a huge percentage of the funds (probably most of them) who fared even worse than the S&P 500 since many of them tried to make riskier bets (such as financials) by calling false bottoms or trying to make up for the horrendous performance earlier in the year. Either way, no one should be surprised that mutual funds are seeing significant outflows of capital ($1.5 trillion net outflows in 2008 according to the Morningstar).

What I do find somewhat surprising is the rate at which ETFs are garnering assets. Morningstar estimates that year to date ETFs have attracted $82 billion in net inflows bringing the current total to $549 billion. That's a year to date growth of 15% in total assets in ETFs! Some of the theories that Morningstar has to explain this trend are:

1. Money aren't flowing into ETFs from the mutual funds alone, but also from the individual stock holdings. With the volatility being what it is nowadays, investors are switching into a more diversified type of asset that they count on to reduce daily volatility.


2. While people who hold mutual funds maybe cashing out or moving assets elsewhere because of the distrust in the active management, asset allocators who use ETFs for the same purposes in their portfolios are sticking to their strategies since they tend to be more sophisticated and patient investors. Therefore, ETF investors continue to contribute to their ETF holdings, while mutual fund investors are decreasing their assets in the mutual funds.
   


3. This is all part of a continuing trend of more investors switching into ETF products from the mutual funds for the purposes of tax efficiency and lower costs.
   

Another point that I find interesting is that just last year a number of articles popped up saying that this ETF frenzy isn't going to last, that the ETF bubble is brewing, that all these obscure ETFs (such as HealthShares Infectious Disease Index and Elliot Wave ETF) are signs of a late-stage bubble that is about to pop. Well, this bubble didn't pop, if anything, ETF product is now proving to be a wise asset allocation tool and a good diversifier.

Additional Resources:

• ETFs Continue to See Strong Inflows Despite the Market
• Who Needs 'Em? The List of Obscure ETFs Grows
• Mutual Funds or ETFs - Which to Choose?