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ETFs Continue to Take Market Share

The latest ICI fund data shows that ETFs continue to take market share from mutual funds.  As of the end of July, ETFs represented 8.6% of all non-money market funds.  In 2005, ETFs represented only 3.5%, notable because that’s the year non-money market mutual funds reached their peak in terms of total number of funds.  Since that time, the number of mutual funds has decreased by 466 and assets in mutual funds have decreased from a peak of $8.9 trillion in 2007 to $6.8 trillion currently. 

While it’s easy to point to the recent market collapse as a primary culprit in the decrease of mutual fund assets, one only has to look to ETF assets to see what’s really driving the decline of mutual funds – investors are realizing the potential benefits that ETFs can offer including lower costs, more transparency, tax efficiency, and better, more direct access to alternative asset classes.  While mutual fund assets have decreased, ETF assets have increased from $608 billion in 2007 to $640 billion currently.

ETFs still have some ground to cover (and it’s important to note that ETFs haven’t even begun to significantly penetrate the 401k space – the key driver for mutual fund assets), but the growth trend is too obvious to ignore.  If you haven’t explored the potential benefits of ETFs, now may be the time to do so.  There’s a reason investors are moving into ETFs and out of mutual funds.

Why Emerging Markets Are Attractive

As the global economy starts to shows signs of improvement, many analysts think that emerging markets are attractive and for good reason.

As these nations build infrastructure and their consumer spending increases, emerging economies often expand faster than their developed counterparts.  In 2008, the gross domestic product (GDP) of both China and Brazil grew more than 7% compared with just 1.1% for the United States.  Much of this growth was fueled by building and improving infrastructure and the relatively low amount of consumer debt found in these nations, which enabled them to expand faster than more developed economies.

Economists expect these nations to continue to grow, which could further create opportunities for strong corporate profit growth, and in turn appreciation in stocks.  However, one must keep in mind that investing in these nations is riskier than investing in developed countries.  Emerging economies can suffer from unstable political, legal and financial systems, volatile currencies and liquidity issues. 

A good way to access emerging markets is through the following ETFs:

• The iShares MSCI Emerging Markets ETF (EEM), which is up 79% from its March low. 
• The Vanguard Emerging Markets Stock (VWO), up 83% from its March low.
• The Emerging Global Shares DJ Emerging Market Titans Composite (EEG), which is a new ETF, but enables investors to grab exposure to parts of the world the other two don’t and is up 5% since its inception.

Protecting Recent Gains

Since the lows struck on March 9th by major US equities indexes, US equities have rallied 50%, international equities 70%, commodities 25% and US REITs 85%!

Yet, if things have been so darned good, then why do most investors feel so badly and so beat up?

The nature of compounding and recovery from negative returns is that it takes a 33.3% return to fully recover from a 25% decline in value.  It takes a 100% return to fully recover from a 50% decline in value and it takes a 300% return to fully recover from a 75% decline in value.

Accordingly, apart from fixed income and relative to October 2007 levels, most asset classes are still 25% to 50% in the hole! … And that’s why most investors still very much “feel the pain.”

So what steps can investors take to help protect recent gains while continuing to participate in the market?

With such extended and disparate gains across equities, fixed income and alternative asset classes and subclasses, it might make sense for buy-and-hold, straight asset-allocation investors to consider rebalancing holdings to their target allocation.

For other investors – and with nearly all asset classes in positive trend – the current environment represents a great opportunity to consider imposing explicit exit protocols underneath individual holdings.  This can help to protect gains and limit losses in the event of a return to extended negative performance, while maintaining market participation in the present and so long as positive trends persist (i.e., transition to an approach to systematically cut losses short while letting winners run).  Nobody gets any merit badges for fully participating in market declines.

Stop-Loss and Sell Stop-Limit Orders

As the investment community continues to trumpet the many potential advantages of exchange-traded funds – including lowers costs, tax efficiency, and transparency, one advantage that is often overlooked is the ability to place stop-loss or sell stop-limit orders on ETFs.  Because ETFs trade intra-day on the exchanges like stocks, investors can utilize tools that aren’t available with mutual funds.

A stop-loss order is simply an order placed with a broker to sell a security when it crosses below a certain price threshold.  For example, if an ETF share is purchased for $25.00 and a 10% stop-loss order is immediately placed on the share, the broker will execute the sale of the share at the market price when the ETF trades at $22.50 or lower.  Note that a stop-loss order doesn’t guarantee the trade will be executed at $22.50, only that the sell order will be triggered.  If the price of the security is deteriorating rapidly, the sale could actually be executed at a lower price.

A sell stop-limit order is similar, except that more precise control can be exercised over the sale price.  If a stop is entered at $22.50 with a limit of $22.00, the sale will be triggered once the ETF trades at $22.50 or lower, but the trade will only be executed if the broker can sell at a price of $22.00 or better.  This allows the investor to ensure they receive a certain price or better for the ETF if the sale order is triggered.  It’s important to note that if the price of the ETF quickly gapped down below $22.00 before the sale could be executed, then the sell order would not be filled (versus a stop-loss order where the order would be filled regardless of the price once the ETF hit $22.50 or lower).

While these types of orders are not for everybody and wouldn’t come into play for traditional buy-and-hold investors, these can be useful tools for more active approaches – particularly in the type of market we’re currently operating in.  After a run-up of nearly 50% in the S&P 500 and given the still uncertain economic environment, many experts are concerned that there could be a significant pullback.  While no one knows for sure what will happen, ETF investors can utilize stop-loss and sell stop-limit orders to ensure they lock-in profits and limit severe drawdowns in the event there is a sharp market decline.  In contrast, with mutual funds, sales can only be executed based on the net asset value of the shares of the fund at the end of each day and also require investors to continuously monitor market events.  With ETFs, investors can tend to their busy work and family schedules or go on vacation and have confidence that downside protection is in place.