ETFs May Transform the Markets

04/10/2007 12:00 am EST

Focus:

Peter Way

Founder and CIO, Peter Way Associates

Peter Way, who writes the Block Traders’ ETF Monitor, says exchange traded funds have many advantages for small and large investors and could mark a sea change in financial markets.

We are watching a sea change in the way equity investments are being pursued.

Decades ago mutual funds marched onto the scene and had a similar effect, offering diversification and continuing professional portfolio oversight to small investors. Their success caused them to largely become the market, and thus most have been unable to show any consistent out performance of the major market indexes.

The creation of far more mutual funds than there are stocks to be invested in allows the trumpeting of performance numbers by whichever ones, by chance, happened to be in the right spots at the right moments. The illusion is thus perpetuated that something of real value is being performed for fund investors at large.

But an increasing number of disillusioned victims are turning to the more economical, more transparent, more manageable, and equally productive alternative of exchange traded funds.

In the past we remarked on the market’s ability to absorb the liquidation of $20 billion of ETFs in a two-week period, without it causing either a panic or enormous operational distress in the functioning marketplace. That was encouraging to us, since price expectations of the volume market makers did not decline alarmingly in the process.

But it illustrates one of the major advantages of ETFs in comparison with mutual funds. Since ETFs trade continuously during the market day, as selling pressures develops they can be disseminated on an ongoing basis. No reserves must be kept by the ETF managers to meet this kind of contingency.

Mutual funds, on the other hand, regularly keep 3%-5% in treasury bills or other immediately liquid securities to meet fund holder redemption demands. Those reserve funds act as a drag on performance, and are part of the reason that mutual funds as a class do not regularly outperform the market averages.

The big difference between mutual fund shares and ETF shares has to do with their effect on the shares of the stocks being held. Mutual fund shares arise from a transaction between the fund holder and the fund’s management company. Redemptions of mutual fund shares can only be performed by the management company.

Transactions in ETFs occur in the secondary market, between investors separate from the ETF management company. Since most ETFs are packages of stocks in well-defined indexes or pre-defined industry groups, markets in the underlying stocks are not impacted by ETF transactions in the same way. When mutual funds are redeemed, the stock investments must be sold in the market.

This makes it possible for big investors to take meaningful positions in groups of stocks quickly and at reasonable transaction costs, with the knowledge that they can dispose of them just as easily. This attraction is drawing more and more big investors into using ETFs as a portfolio management tool.

So there are really two distinct demand groups supporting the growth of investments in ETFs—professional investors and individual investors (largely former mutual fund investors).

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