FRC Study Examines Future of ETFs By John Spence November 6, 2000

With large financial institutions launching an explosion of exchange-traded funds (ETFs) around the globe, some have questioned whether these investment products represent a threat to traditional mutual funds. Can ETFs exact a fundamental change upon the mutual fund industry, or is this just noise?

Boston-based Financial Research Corporation (FRC) recently published a study that examined the issue. FRC interviewed and surveyed:

• institutional experts in the field
• brokers and planners that use ETFs in client portfolios
• retail investors that have either purchased ETFs or inquired about them
• 800 general retail investors (represent future potential demand for ETFs)

Will ETFs replace mutual funds?

Notes: The FRC study also examined the future of actively-managed ETFs, but this article focuses mainly on data concerning existing index-based ETFs unless otherwise indicated. The FRC research was sponsored by Barclays Global Investors.

When asked point blank if ETFs represent a significant challenge to index mutual funds, 85% of institutional experts responded that they already are. The remaining 15% said that ETFs would emerge as a significant challenge within the next three years. Additionally, 70% of the experts expect that ETFs are likely to take substantial market share away from index funds.

As far as asset growth for ETFs, the panel of institutional experts forecasted 30%-50% average annual growth rates over the next five years. According to this prediction, assets in ETFs as a percentage of total indexed fund assets will be as high as 27% in five years, compared to 8% presently. The average prediction for total assets of index-based ETFs in five years was $201 billion, though some estimates ranged as high as $500 billion.

Retail investors that own ETFs or are interested in ETFs were asked how they would finance ETF purchases, and 60% indicated they would sell or forgo purchasing individual stocks. This majority response runs contrary to the idea of ETFs replacing traditional mutual funds.

Similarly, a majority of 800 general retail investors indicated that ETFs are more likely to take business away from individual securities than mutual funds.

What are we to conclude from these numbers?

For one thing, institutional experts see ETFs as a threat specific to index funds, not to actively-managed funds. Investors, for their part, indicated that ETFs are more likely to take away assets from individual stocks than from mutual funds. Although ETFs will drain a portion of assets from mutual funds, the claim that they will replace traditional mutual funds may be exaggerated. Only one-third of experts agree that even actively-managed ETFs will significantly challenge actively-managed mutual funds, and a majority also agree that the first actively-managed ETFs won't be launched until at least 2002.

Of note

FRC also surveyed professional brokers and planners that use ETFs, and some interesting attitudes came to light. They said they use ETFs in 18% of their clients' portfolios, while allocating 11% of their clients' total assets to ETFs. When asked how they use ETFs, 55% of brokers indicated the main reason for using ETFs was primarily for long-term buy-and-hold strategies. The remaining 45% said they used ETFs for an even mix between trading and buy-and-hold strategies.

Retail investors that use ETFs or have inquired about them were likewise asked how they plan to use ETFs in their portfolios. Seventy-five percent said their intention is to use ETFs primarily for buy-and-hold strategies, while 25% said they would use ETFs for a mix of long-term and trading strategies