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The Era for ETFs

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I read Morningstar Advisor last month, and have come to the conclusion that this is indeed the era for ETFs.  For the 15 years that I’ve been in the investment business, Morningstar has focused most of their attention on the mutual fund industry.  They developed, and have modified, a mutual fund star ranking system, and they have an extensive fund research platform.  But this month, they turned their attention to ETFs; and for good reason.  For the twelve months through June of 2011, actively managed mutual funds saw outflows of $66 billion, while ETFs saw that same $66 billion figure flood in.

A Morningstar bigwig stated, “The future belongs to low-cost, passive strategies—and the most efficient vehicle to deliver that type of investing—ETFs.  The 70-year-old mutual fund structure served its investors well, but it’s time to move on.  There’s a rapid adoption of fee-based and fiduciary advising models.  These advisors want to keep costs low, stay diversified, and not churn the portfolio.  They buy the best performing funds—not the best paying—driving the flows into passive and low-cost vehicles at astounding rates.”

The editor of Morningstar Advisor says, “With just one tenth of the assets that mutual funds hold, ETFs have a long way to go before they become the investing vehicle of choice for most Americans.  But if we are entering a fee-based, fiduciary age, when efficiency and low costs become paramount, the ETF industry is in a prime spot to offer what advisors and investors will demand.” 

The reason for the shift from mutual funds to ETFs, Morningstar opines, comes down to technology.  Mutual funds are from the 1940s, and ETFs are from the digital age. Why should investors have to wait until the end of the day to know what price they paid for their shares?  Would you buy a car that way?  Would you go to the dealer at 10 a.m. and say, “I want to buy that SUV,” only to have the salesman tell you that you should give him $16,000 now, come back at 3 p.m., and then after everyone else has bought their car, he’ll tell you how much car you bought?  Of course not, but that is how mutual fund technology works.

With ETFs, technology has made intra-day trading possible, and tax efficiency is improved with the injection of a secondary market in addition to a primary one.  Disclosure is also more transparent with ETFs.

Morningstar concludes with this statement, “In the end, the investor is the winner and “fee eaters” and “commission addicts” are the losers.  Investments will be “bought”, not “sold” as would happen in any efficient capital market. At least, that’s our theory.”  Ours too.