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Nearly everyone has suffered from the market's free fall. Everyone that is, except for one unexpected beneficiary of the collapse: the ETF industry.
Think about it: Before the bear market hit, exchange-traded funds had established a pretty strong foothold in the fund arena. As a broker-traded alternative to index mutual funds, ETFs had some fairly compelling features to offer. Top ETFs like the SPDR Trust (NYSE: SPY ) became household names among investors, offering the chance to buy an S&P index fund on the open market.
But the end of the bull market brought with it a sea change in the way many investors look at their investments. And no one was better poised to take advantage of that change than the companies that produce ETFs.
Going with the latest fad
It's no coincidence that ETFs started appearing in close succession with new investing fads. When oil spiked over $100 a barrel and energy companies like ExxonMobil (NYSE: XOM ) and Chesapeake Energy (NYSE: CHK ) rose to all-time highs, a host of energy ETFs were there to give shareholders vehicles tied not only to baskets of stocks but to the prices of oil and gas directly.
Similarly, the commodities boom that pushed stocks like PotashCorp (NYSE: POT ) and Monsanto (NYSE: MON ) to big gains was also responsible for spawning an explosion in commodities-related ETFs. You could find funds that measured custom-made indexes of commodities prices, as well as others tracking top-performing stocks in those industries.
Kicking into overdrive
As lucrative as those ETFs were for investors, though, they weren't the only way to make money in those bull markets. Where ETFs really shined, was when stock prices started falling.
Most investors don't feel comfortable selling stocks short, and few have access to hedge funds or other investment vehicles that profit when the stock market drops. So when the market fell, bear market ETFs were virtually the only game in town for those wanting to make money.
And make money they did. As the crisis in financials spread past Bear Stearns and Lehman Brothers to pull down shares of stronger rivals like JPMorgan Chase (NYSE: JPM ) and Wells Fargo (NYSE: WFC ) , what was the easiest way to make money? An ETF, Ultrashort Financials ProShares (SKF), which has nearly doubled just since the beginning of 2009. And with stocks of all kinds down sharply, broader bear market ETFs flourished as well, with the Ultrashort S&P 500 ProShares (SDS) ETF up 62% in 2008 and another 55% so far this year.
Don't forget about the long term
In the ETF craze, though, investors chose to ignore one thing: the need to think about their investments over the long haul. Leveraged ETFs can be useful for those willing to make a big bet on a short-term move, but over time, they have much greater risk than regular mutual funds. But because regular mutual funds own stocks, and nearly all stocks have dropped in value lately, regular mutual funds appear backward and out of touch with the times.
Even though ETFs have a big advantage in the current market environment, don't count out mutual funds yet. Sure, market professionals have been thrown for a loop as their attempts to find stocks that can swim against the tide have mostly failed. Fund investors are tired of seeing losses, and so assets under management will likely continue to fall and managers will have less money to work with.
But the best funds still have something ETFs don't -- the ability to change gears when the market changes. If you invest in a bear market ETF that bets against financials, it's up to you to get out if you think financials are poised to rebound -- if you don't, you could lose all your profits and then some. Active funds, on the other hand, can adapt to changing conditions and find the best place to make money.
Even though many fund managers don't beat the indexes, many investors still see value in having investing professionals looking after their money. Until stock ETFs find a way to combine active management with the transparency that the ETF model requires, mutual funds will still play a useful role in investors' portfolios.
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