Exchange-traded funds entering new phase of growth

The headlines about exchange-traded funds suggest there are no limits to the growth of these low-cost, easily traded alternatives to mutual funds.

Among the recent developments: ETFs have attracted at least $100 billion in new cash for each of the past six years, growing at a far more rapid pace than traditional mutual funds. ETF assets have doubled over the past three years to $1.4 trillion, with one study projecting they'll hit $3.5 trillion by 2016. ETFs have recently begun to appear as investment options in 529 college-savings plans and 401(k)s.

Yet obstacles are beginning to appear. It has become more difficult for fund companies to launch ETFs that are significantly different or lower-cost than what's already on the market.

"We're close to a tipping point in terms of numbers," says Todd Rosenbluth, director of ETF research at S&P Capital IQ.

The number of ETFs may decline this year, something that's unprecedented in the two decades since the first ETF was introduced. Through the end of March, there were 1,190 ETFs, or three fewer than at the same point a year ago, and four fewer than at the end of 2012, according to the trade organization Investment Company Institute.

Many aren't attracting enough cash to remain financially viable. Eighty-one ETFs were closed last year. Although that's fewer than the number that were launched, that total broke the previous record of 51 ETF liquidations set in 2010.

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It may be too late for any company to become competitive in ETFs if it doesn't already have a presence in the field. Some traditional fund companies are playing catch-up by partnering with existing ETF providers, and distributing those ETFs to their own brokerage customers. Fidelity Investments, for example, announced in March that it was ramping up its small presence in ETFs by expanding a 3-year-old partnership with BlackRock's iShares unit, the largest ETF provider. Fidelity will rely on iShares' index ETF lineup to pitch to its own customers, rather than launching Fidelity-branded ETFs that passively track indexes.

So why might an average investor care? Index mutual funds have long been the first choice for anyone looking to invest on the cheap, but the fees of the lowest-cost ETFs are now undercutting index funds. That's in part the result of a recent round of cost competition, with ETF providers including Charles Schwab, iShares and Vanguard reducing investment management fees.

Similar to index mutual funds, ETFs track segments of the market and try to match a benchmark stock or bond index rather than beat it. But ETF shares can be traded throughout the day like stocks. That makes it possible to lock in a preferred price without waiting for a closing price. Mutual funds are priced only at the close of daily trading.

Rosenbluth, of S&P Capital IQ, discussed the latest ETF industry developments in a recent interview:

Q: Why might the number of index ETF launches continue to decline?

A: It's hard to differentiate some of these products. There's no need for a fourth or fifth product tracking the Standard & Poor's 500 stock index, when there are already two low-cost dominant products: State Street's SPDR S&P 500 and the iShares S&P 500 offering. If you're another company trying to compete with those ETFs, to bring expense ratios down and become cost-efficient, you have to gather a huge amount of assets. What would a company like Fidelity gain from offering a Fidelity-branded S&P 500 ETF? There would be a risk that the company would cannibalize the money flowing into Fidelity's existing S&P 500 mutual fund.

Q: An increasing number of ETFs can be traded commission-free, with restrictions. Should the availability of commission-free trading be a major consideration?

A: If you're a self-directed investor who trades a lot, that's the way to go. But if you work with a financial adviser, as is the case with a lot of people, you may already be paying a commission to invest, and it comes down to whether the ETF you buy is a good product.

The commission-free feature for some ETFs helps offset the fact that some of these ETFs may not be competitive in terms of the expenses they charge. So if you add the two up, they might cancel each other out, and you'll be about equal.

Q: Should the expanded availability of commission-free ETFs affect how average investors construct their portfolios?

A: Investors have greater access. But just because there's no trading commission doesn't mean it's a good ETF. It may not be a good product, or it might not be appropriate for that investor based on their appetite for risk.

For example, ETFs investing in high-yield bonds generate yields of about 5 percent. That's favorable in a market where 10-year Treasurys yield less than 2 percent.

But that extra yield comes at a cost, because the high-yield ETF will invest in junk bonds, with a significant risk of default. So just because it's a commission-free ETF doesn't mean it makes sense for someone approaching retirement to have in their bond portfolio.

AP Personal Finance Writer