ETF Update: Indexing Options, ETF Boom, ETFs and RIAs, Rebound ETFs

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Includes: EFA, EWJ, IYR, RSP, SPY
by: Tom Lydon

Topics covered in this update: Indexing Options, ETF Boom, ETFs and RIAs, Rebound ETFs

Indexing Options Grow
Investing in ETFs used to be simple. Investors picked one that mimicked the S&P 500 and received a fund that often beat most actively-managed funds. However, as more ETFs and indexes are created, ETF investing has become more complicated.

For example, it used to be that all indexes were market-cap weighted, which is considered the traditional approach to indexing. It's calculated by multiplying the stocks' quoted price by the number of shares outstanding, which means it tends to favor larger companies and growth stocks, according to Janice Fioravante for The Christian Science Monitor. Today, fundamental indexing has created competition for the traditional approach. This strategy tends to favor smaller companies and value stocks. Another approach is an index that equally weighs all the companies within it. An example of an ETF that tracks this type of fundamental index is the Rydex S&P Equal Weight (NYSEARCA:RSP).

Other versions using the fundamental indexing-approach include the Research Associates Fundamental Index [RAFI] index and the dividend index. The RAFI index uses sales, dividends, earnings and book value to weigh its holdings. As imagined, the dividend index is based on holdings' dividends and earnings.

Read the full disclosure, as Tom Lydon is a board member of Rydex Investments.


ETF Boom

It's no news that the ETF business is booming. The total number of ETFs was 542 as of the end of June, and 162 of those were launched in the first six months of this year, according to Scott Burns for The Dallas Morning News. Oodles more are on the way. To get an idea of how fast this industry is growing, Burns looks to the history of mutual funds and index funds for comparison:
  • It took mutual funds 56 years before they reached the same number ETFs have in 14 years.
  • It took index funds 25 years before their numbers reached 542.

With so many new ETFs on the way, they will enter a market already overflowing with choices. More options provide investors with more opportunities to find ETFs that match their financial goals. However, this also means that investors will have to do more research to understand the differences among all the ETFs. In a world with better educated investors, everyone wins.

By 2011, total assets under management globally in ETFs are expected to surpass $2 trillion, which is up from $669 billion as of June 30, according to a report by Morgan Stanley. Some possible causes behind the growth, according to Pensions & Investments for Investment News, include:

  • ETF expansion into new sectors and regions
  • Larger allocations by U.S. and European investors
  • Managers increasing the number of products brought to the market
  • The U.S. has the most active ETF market with 1,559 institutions using ETFs, as of Dec. 31 last year. The most widely used ETFs worldwide as of that time are:

  • SPDRs (NYSEARCA:SPY) - 1,067 users
  • iShares MSCI Japan Index (NYSEARCA:EWJ) - 681 users
  • iShares MSCI EAFE Index (NYSEARCA:EFA) - 671 users

  • ETFs and RIAs

    Good news: The use of ETFs as the primary investment vehicles for registered investment advisers (RIAs) is becoming increasingly popular. Better news: The fastest growing adviser segment are those advisers with a broker/dealer affiliation and their own RIA for providing fee-based advice, according to research by Cerulli Associates. The trend toward independent advice continues to grow exponentially, and more independent investment advisers like us are catching on to the ETF advantage.

    According to "Intermediary Markets 2007," the independent advisory channel has grown from approximately $950 billion in 2005 to more than $4 trillion at the end of 2006, reports Melanie Waddell for Investment Advisor.

    Rebound ETFs
    There might be some hope for ETFs that have been kicked around by market volatility the last few weeks. The sectors and stocks that pulled back first and fell the hardest are also the ETFs that have been sold the most either from long or short sales, say John Hughes and Scott Maragioglio for TheStreet.com. This is good news because those that got beat up the worst tend to recover the best.

    Take REITs for example, such as the iShares Dow Jones U.S. Real Estate (NYSEARCA:IYR). First, real estate concerns brought IYR down, then it was pummeled by credit concerns. For now, this ETF is seems to have stabilized. It's up 7% from the market's recent low on August 15. IYR's rally is a good short-term price action that suggests selling has abated for now. Before investing in any rebound ETFs, investors must make sure they fit with their portfolio needs.

    IYR 1-yr chart: