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Is this the beginning of the end of ETFs as an asset class? Ian Salisbury has an important story this weekend, saying that the average ETF underperformed its benchmark by 125bp in 2009, and even the monster SPY underperformed by 19bp. That’s more than twice its total expense ratio.

The problem is that when ETFs become very big, they become lumbering and predictable, and nimble hedgies know exactly what they’re going to do and when they’re going to do it. As a result, the smart money front-runs the dumb ETFs, which end up underperforming, sometimes by a very large margin: the $40 billion iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM) lagged its benchmark by a whopping 6.7 percentage points in 2009. That’s over nine times its total expense ratio.

So while it’s a good idea to avoid small ETFs, and to avoid commodity-based ETFs as well, even the biggest, safest ETFs are beginning to look as though they might have reached a level of size and popularity that makes them suboptimal investments. That’s sad, if true, because they were great while they lasted, and because there’s no real alternative out there.

But the fact is that there’s no rule of investing saying that there is always an easy and obvious investment strategy for people of relatively modest wealth. Investing involves taking a large number of risks, some obvious, some less so. And if ETFs continue to underperform in 2010 to the same degree that they underperformed in 2009, their repo income notwithstanding, then ETFs — which looked for a while there as though they really might be that rarest of animals, a positive financial innovation — might well turn out to be a grave disappointment for millions of investors who thought they could make a handful of asset-allocation decisions and then sit back doing little if any more work from then on.

We’re not quite there yet: as Salisbury points out, EEM is still outperforming its benchmark since inception, and it outperformed in 2008. And for long-term investors, a single year’s underperformance shouldn’t matter a great deal. But if this turns out to be something newly endemic to the asset class, there might well be no cure for the problem — and that’s worrying, given how popular ETFs have become.

Update: On the other hand, if EEM is good enough for the Harvard endowment to have $388 million in it…

Source: ETFs Start to Underperform