The Rising Fame of ETFs

It certainly hasn’t happened yet, but Cerulli analysts say exchange-traded funds (ETFs) could rival mutual funds if they become widely adopted in defined contributions plans.

According the most recent The Cerulli Edge—Advisor Edition, the “final frontier’ for providers is the 401(k) market, which gave mutual funds their “household-name’ status. Some firms have already teamed up with recordkeepeers to offer platforms allowing block trading for participant accounts, mostly in the small to mid-size market.

Of course, there are many obstacles to ETFs experiencing wide adoption in the 401(k) arena (see Hard to Fit). Cerulli notes that the largest and most costly hurdles are technology and operations. ETF providers might be eager to enter the 401(k) market, but most do not want to become recordkeepers in the process, Cerulli says.

“Without doubt, if ETFs end up on 401(k) platforms, more asset managers will look to enter the ETF space,’ according to the report. Consequently, adviser usage would increase as more investors became comfort with the products—much like mutual funds.

More Advisers Use ETFs

Although how ETFs will fit into 401(k) plans is yet to be seen, meanwhile, their uptake in retail accounts has been rapid. More than half (54%) of ETF assets are now held in retail accounts, according to Cerulli.

The adviser uptake of ETFs continues to rise as the number of fee-based advisers rise (see Advisers Report ETF Uptake). As many advisers no longer rely on commissions, they are free to look outside the mutual fund box. According to Cerulli, in 2002, 34% of advisers were fee-based, and ETF assets stood at $102 billion. At year-end 2007, both of those numbers were much higher: 54% of advisers were fee-based and ETF assets had grown to $613 billion.

The report describes your “typical ETF user’ as a fee-based adviser with high-net-worth clients, often working in a registered investment adviser (RIA) firm. Tax-sensitive high-net-worth clients with large balances outside of qualified plans are often a good fit for ETFs. Advisers outside of the prototype, however, are also using ETFs more.

Among advisers, RIAs are still the heaviest users of ETFs, with an average ETF allocation of 12%, compared with wirehouse advisers, who have an average 6% allocation. Cerulli calls the “elephant in the room’ the lack of revenue-sharing agreements with these vehicles. No ETF provider is participating in a revenue-sharing agreement, which is a significant source of income for large broker/dealers.

When it comes to how advisers use ETFs, Cerulli says it is often in the place of active products rather than index products. Advisers are continuing to find creative uses for ETFs, blending them with active products, using them alongside managed accounts, and building institutional-quality portfolios. According to the report, the primary reason advisers use ETFs is “diversification to stabilize portfolio returns’ (38%), followed by using ETFs as a core holding (29%). A quarter of advisers still say they have not used ETFs (25%). Much lower percentages of advisers use ETFs to generate income and alpha (4% for each).