The ETF Year in Review

By many measures 2005 was another strong year for exchange-traded funds. A record number of new ETFs began trading; asset growth and inflows stayed healthy; and awareness of and interest in ETFs spread. There were also signs that ETFs finally had injected some much needed price competition into the fund industry, as Fidelity Investments cut the expense ratios of its traditional index funds and Vanguard lowered the fees for some of its funds' exchange-traded share classes. Lower costs are always better for shareholders, but ETFs also continued to make good on their promise to deliver tax-efficient equity exposure to shareholders. Most of the funds avoided capital gains distributions in 2005. The following is a look at the year that was and the year that will be for ETFs.

Leaders and Laggards
ETFs, which are all still index funds, acted like their counterparts in the conventional mutual fund universe. Most broad equity ETF categories ended the year in positive territory. Broad market ETFs, such as  Vanguard Total Stock Market VIPERs  (VTI) and  StreetTracks Total Market ETF (TMW), were up more than 6% for the year to date through Dec. 30, 2005.

International and energy-focused ETFs turned in the strongest performances. Latin America, emerging-markets, and natural-resources funds, buoyed by soaring energy and commodity stocks (such as oil company Petroleo Brasileiro), led the way. IShares MSCI Brazil (EWZ) and iShares MSCI South Korea (EWY) were especially robust, each gaining more than 50% through Dec. 30. The  Energy Select Sector SPDR (XLE) and  Vanguard Energy VIPERs (VDE) still posted robust gains of about 40%, despite stumbling as oil prices moderated in the fourth quarter.

Communication, technology, and large-growth ETFs turned in the worst performances, though only the average communications fund lost money. The iShares S&P Global Telecommunications Index (IXP) shed 6.7% through the end of December as large holdings such as phone service providers  Vodafone (VOD) and  Verizon Communications (VZ) got hammered over concerns about risky acquisitions and fierce competition.

When You're Hot, You're Hot
More new ETFs hit the market in 2005 than ever before. In terms of sheer numbers of new funds launched, 2005 was the year of PowerShares. Of the record-breaking 51 new ETFs to hit the market in 2005, PowerShares Capital Management launched 32, or more than 60% of them. The Wheaton, IL-based firm has quickly established itself and pushed the boundaries of ETFs with its quasi-actively managed funds, but most of its offerings track little known or dangerously narrow benchmarks. In its rush to offer offbeat ETFs, the firm risks becoming a fun house for trend chasers rather than a source of responsible investing tools.

There were no blockbuster new offerings. The biggest new ETF in terms of assets,  Vanguard Emerging Markets Stock VIPERs (VWO), which launched in March 2005, had $450 million by the end of November, beating iShares Comex Gold (IAU), which rolled out in January 2005 and had more than $300 million. That's a far cry from 2004's biggest launch,  StreetTracks Gold Shares (GLD), which gathered more than $1 billion in a few weeks. The Vanguard Emerging Markets VIPER deserves some attention because it has a lower expense ratio than its closest rival,  iShares MSCI Emerging Markets (EEM). Each of these funds, however, is in a hot category (emerging markets and precious metals), and it's usually a bad idea to chase performance.

ETFs kept growing in 2005. In the first 11 months of the year total ETF assets grew to $289 billion, or 28% from the end of 2004, according to the Investment Company Institute. Net new issuance of ETF shares was running a little ahead of 2004's pace, according to the ICI. Through Nov. 30 ETFs issued $48 billion in net new shares, versus $46 billion for the same period last year.

Barclays Global Investors' iShares family remains the biggest of the ETF groups. Indeed, though the end of November Barclays was one of fastest growing fund families, exchange-traded or otherwise, of 2005; iShares garnered $39.3 billion in net new money and had more than $116 billion in total assets, according to Financial Research Corp. The most popular iShares included the broad-based international fund,  iShares MSCI EAFE (EFA), which was one of the 10 best-selling funds of all kinds with $6.5 billion in net inflows through the first 11 months of the year, according to FRC. IShares MSCI Emerging Markets and  iShares MSCI Japan (EWJ) also were hot sellers, taking in nearly $4 billion in net inflows each. There's a good case to be made for investing overseas, but single-country and emerging-markets funds are notoriously volatile, and buying them solely for their recent strong absolute performance is a bad idea.

Shifting Allegiances
There were some significant changes behind the scenes in the ETF industry in 2005. Perhaps the biggest was Barclays' July announcement that it would move 81 of its iShares' primary listings from the American Stock Exchange, where ETFs were born, to the New York Stock Exchange and the Archipelago Exchange (the two exchanges are merging) over two years. By November, Barclays had already shifted 40 of its ETFs to the NYSE. The rest will make the move in 2006 and 2007. Individual retail investors will likely notice little difference, but Barclays has said Archipelago and NYSE's improved technology will help facilitate the growing iShares lineup.

A Faster Track?
Much sooner than expected, the Securities and Exchange Commission approved the first ETF based on currency. The Rydex Euro Currency Shares (FXE), which tracks the price of the European Union's currency versus the dollar, began trading in December. We're not that excited about the fund as an investment; currency movements are too fickle for most investors to mess with. The offering's relatively quick approval (less than a year) could be a sign that the SEC is getting more comfortable with exotic ETF proposals. Previously, alternative asset class ETFs, such as those tracking the price of gold, had taken nearly two years to secure approval.

Barra Gets the Boot
Standard & Poor's, which publishes the style-based equity benchmarks used by iShares and dozens of other funds, decided to drop a style index construction methodology (developed by risk-management firm Barra) that relied only on price/book value to determine if a stock should be classified as growth or value. There is a lot of academic work supporting the use of price/book value as a gauge of growth or value; in reality, however, relying on one factor has undesirable ramifications for index funds. The Barra S&P style indexes proved to be unrealistic measures of the growth and value universes and forced index fund managers to turn their portfolios over more often as stocks migrated based on their price/book values.

Those were among the reasons Standard & Poor's adopted new style bogies derived from a multifactor model created by Citigroup (C). The Citigroup indexes will still draw their constituents from the same S&P large-, mid-, and small-cap indexes, but it will look at seven valuation and growth factors instead of one to figure out where a stock belongs. Unlike the Barra indexes, they will also allow stocks that have both value and growth characteristics to reside in both value and growth indexes, which should control turnover. Barclays' iShares funds began tracking the new indexes in December 2005.

Index Fund Price War
Fidelity Investments put some pressure on ETFs as it tussled with Vanguard. Fidelity first cut the retail share class expense ratios of its conventional equity index funds to a competitive 0.10%. Later it rolled out a new Advantage share class for its index funds that charged an even lower 0.07% for investors with at least $100,000. The move was aimed at rival Vanguard, which has long offered cheaper Admiral share classes for big investors. But the battle also throws a gauntlet at the feet of ETFs. The expense ratio for Fidelity's Advantage class matches the cheapest ETFs', and unlike ETFs, Fidelity's funds can be bought without a commission. The Fidelity offerings, regardless of share class, are therefore likely better choice for investors putting money into their funds on a regular basis.

What's Next?
Investors can expect more alternative asset class ETFs in 2006. The SEC has approved the Deutsche Bank Commodity Index, which will use futures to track a production-weighted benchmark of aluminum, gold, wheat, corn, heating oil, and sweet light crude. Barclays has a similar offering in the works: iShares GSCI Commodity-Indexed Trust. There's also an iShares Silver ETF and several funds that plan to track the price of oil waiting in the wings, though they all may not secure regulatory approval.

There will be more action on actively managed ETFs. A handful of firms have filed applications with the SEC or proposed active ETF formats, including the American Stock Exchange and a firm founded by a former Amex executive. It remains to be seen, however, if the wait will be worth it.

It's possible someone will introduce more fixed-income ETFs; there are still only six. Investors are also sure to see more ETFs tracking indexes purporting to offer an alternative to traditional market-cap weighted indexes. Rydex Investments, for example, hopes to launch six ETFs based on the "pure" versions of the S&P/Citigroup style benchmarks that weight their constituents by their style scores.

Judging from the frenetic pace of ETF launches we saw in 2005, its safe to say investors will see a fair amount of trend hopping. For example, there were five new dividend focused ETFs launched in 2005 and Barclays, State Street Global Advisors, and PowerShares all rolled out or planned to roll out more thinly sliced ETFs tracking hot areas, such as homebuilding or the oil and gas industries. Just remember if they build it, you don't have to come--until you're sure it fits your goals and risk profile.