Friday, June 18, 2010

ETF Elephant in the Room

Morningstar reported earlier this month that U.S. Exchange Trade Funds (ETFs) experienced $4.8 billion in money inflow during the month of May 2010, bringing total inflow for the year-to-date to $24.7 billion. ETF assets at the end of May 2010 were $792.6 billion. This compares to $785 billion in assets at the end of December 2009, suggesting that net inflows in the first five months of the year were $7.6 billion. The ETF vehicle is compelling. ETFs give investors a single security that can be traded intraday along with the usual benefits of an indexed fund: low turnover, low cost, broad diversification and low expense ratios.

Mutual funds saw significant outflow of $15.0 billion in assets in the first five months of 2010. Money flow is not the only issue. A mere 80 new mutual funds were launched in 2009, compared to 134 new ETFs. Heavyweights PIMCO and Charles Schwab entered the ETF market in late 2009, signaling that the ETF category is here to stay and likely to get bigger in the years to come.

I believe the flow of capital into ETFs has implications for capital formation in general and the small cap sector in particular. Most ETFs are passively managed, tracking one index or another. Granted there is a new interest in actively managed ETFs. We count at least seven firms, including Legg Mason, Eaton Vance, and Dreyfus among others, that have or are launching actively managed ETFs. However, there are still less than two dozen actively managed ETFs.

Consequently, we expect more capital to fall under the umbrella of passive investment strategies that eliminate the careful consideration of fundamental developments in buy, sell or hold decisions. This is not a argument against indexed investing strategies, as I have no disagreement with the approach. However, it is a call to awareness among small cap corporate leadership and direct investors in small caps that the proliferation in passively managed ETFs and the net flow of capital to those vehicles could impact the availability of capital for company-specific investment, i.e. follow-on stock offerings or private placements of public equity (PIPEs).


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