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by Anthony Harrington

By their very nature, Exchange Traded Funds (ETFs) are a beta play. You get the market performance, not outperformance, but that only tells a fraction of the ETF story. Basically, because they are so liquid and easy to get in and out of, ETFs offer investors a chance to get active with passive management. They are an ideal way of climbing on a bandwagon almost instantly and if you are a momentum investor, jumping on an ETF that is surging is as good a way as any of generating short term - even exceedingly short term - outperformance. Similarly, if an ETF goes flat, you can bail it instantly and put your money to work in one that has just started to fly, or that is already screaming away from the pack.

They are also an extremely easy way of gaining exposure to a whole raft of exotic plays, from sector specific ETFs, to highly stylized slices within a specific sector. Basically, if you can think of a cluster of stocks, commodities or bonds you'd like to back, the chances are that an ETF specialist house has already devised an ETF that matches that very requirement. Small wonder then that money just seems to keep pouring into the sector, despite the giddy heights being reached by the major stock markets. U.S. listed exchange traded funds attracted some $188.4 billion in 2013, almost topping the all time record for a year, $190.1 billion, set in 2012.

According to the research and consultancy firm ETFGI, which specializes in ETFs and Exchange Traded Products (ETPs), and which tracks some 4,700 ETFs and ETPs on 9,500 listed exchanges around the world, inflows to the global ETF/ETP market in December 2013 totaled some $24.5 billion, pushing global ETF/ETP assets to a new record high of $2.4 trillion as at year-end 2013. In total, there were just over 5,000 ETFs and ETPs, with 218 providers. The provider attracting the greatest inflow of funds was iShares, according to ETFGI's managing partner Deborah Fuhr.

According to Michael Rawson, the one ETF category that tanked in 2013 was emerging markets, with investors selling some $6.6 billion from diversified emerging market ETFs, but the overall ETF story was very strong. A number of ETF funds now have major institutions holding the majority of their shares. Rawson reckons that ETFs such as Vanguard's FTSE Emerging Markets ETF and the iShares MSCI Emerging Markets product are around 65% owned by institutions. They get exposure and they get liquidity. When emerging markets started to nose dive in reaction to the Federal Reserve's talk of tapering they can lower their exposure very rapidly. As Julie Segal notes, the May taper fiasco gave institutions an ideal opportunity to test the theory that ETFs would make it easier for them to maneuver in illiquid and volatile markets, and the theory worked, more or less.

Segal also points out that the same argument about liquidity applies in spades to bond funds. Buying individual bonds can leave you hunting around for a buyer if you want to exit before the bond's maturity. A bond ETF, by way of contrast, is simply a unit sale in a liquid market. Segal makes the point that bond markets have become somewhat more illiquid in recent months as the normal activities - or what used to be the normal activities - of banks in the bond markets are inhibited by capital reserves rules and restrictions around proprietary trading. So rather than holding individual bonds, buying into any of a number of bond ETFs makes good sense for institutional investors.

This point is further developed by EDHEC in a paper entitled "The benefits of bond buying for institutional investors." At the end of a detailed study, EDHEC concludes that working through ETFs rather than building individual bond portfolios allows institutional investors "to implement state of the art risk management practices, without necessarily having to deploy the extensive human resources and large material infrastructures needed for a similar level of sophistication in the management of individual bond portfolios." Says it all, really, doesn't it?

Source: ETFs Beat Mutual Funds To Finish Near Record Highs In 2013