Last Tuesday we posted three charts showing that even after expanding at a much faster clip than open-end mutual fund assets for more than a decade, exchange-traded funds remain a modest part of the asset management business.
We closed that item by noting that the big question in the industry isn't so much the rise of ETFs per se (as interesting, important, and useful as they might be), but about the future prospects of long-only money management delivered through big, diversified, expensive mutual funds.
Today we have three more charts, each telling the same story in its own way.
First, a side-by-side comparison of open-end index fund and ETF assets (in blue) and non-indexed open-end fund assets (in red). All data are courtesy of the Investment Company Institute.
Next, the same data stacked to clarify the relative percentages of index-based (blue) and actively-managed (red) assets.
Finally, a year-end 2006 snapshot of indexed and non-indexed assets in six categories.
We first wrote about these data back in October. We still like what we wrote then:
Naturally, the largest percentage is in the "S&P 500" asset class of large-cap domestic equities, where investment vehicles like Vanguard 500 and SPY have accumulated tremendous assets over the last couple decades. But note how anemic the index/ETF percentages are in all the other categories. On a dollar-weighted basis, the average across all categories is 13.7%. Let's put that another way: 86.3% of investor assets incur significant fees to chase after a mirage.
And given what we know about investor behavior, the average investor's actual returns are significantly lower than those of the mediocre products in which they invest. That just isn't a pretty picture.
The introduction of actively-managed ETFs will require another level of subtlety in this kind of analysis.
As we see it, actively-managed ETFs should have some of the strengths that make index-based ETFs so attractive: trading flexibility, modest explicit expenses, and relative tax-efficiency. Rapid portfolio turnover could diminish this last advantage, depending on the effectiveness of specific ETFs' creation/redemption processes. On the other hand, actively-managed ETFs could suffer from some of the weaknesses that afflict open-end mutual funds: consequential implicit costs, non-trivial market impact, excessive diversification, benchmark-hugging, and, of course, the risk of sustained underperformance.
Savvy investors will do more than just decide between "active" and "passive." They'll pay for active management only in vehicles that have a plausible chance of delivering what successful active management offers (but can't guarantee): prudent risk management and attractive absolute returns over entire market cycles.