Exchange-traded funds have changed the entire investing landscape. Even if you never buy shares of an ETF, the number of investors who rely on ETFs is on the rise -- and if you don't know what trends they're following, you could miss out on some big investing opportunities.
Looking back
Schwab (NYSE: SCHW) recently released its 2010 review of ETF investing trends. Although Schwab drew all of its data from its own customer base, the discount broker's combination of retail and institutional clients provides some insight into the different ways that various types of investors are using ETFs in their portfolios.
On the broadest level, it's clear that ordinary investors have become much more comfortable with ETFs. Schwab's pool of retail investors -- mostly made up of people who make fewer than 36 trades in any given year -- saw its ETF assets rise 61% last year to roughly $41 billion.
But what's more interesting is how Schwab's retail clients got interested in ETFs. According to the review, many investors initially paid attention to ETFs that gave them access to what Schwab calls "satellite opportunities" in niche investments like sector ETFs, foreign country funds, and commodity ETFs. In other words, high-profile ETFs SPDR S&P 500 (NYSE: SPY) and PowerShares QQQ (Nasdaq: QQQQ), with which longtime investors are all familiar, aren't what get novice investors interested in ETFs. Rather, specialty ETFs including SPDR Gold Trust (NYSE: GLD) and Vanguard MSCI Emerging Markets (NYSE: VWO), which offer targeted exposure to narrower segments of the market, bring investors in the door -- and then they diversify beyond those niche offerings after they get comfortable with the ETF concept.
That's quite consistent with the results of Schwab's survey of the independent advisors who use its services. Among them, 83% of clients use ETFs for portfolio diversification. Other popular purposes include using ETFs as a placeholder while considering specific investments, managing risk, and using them as an aid to managing the tax consequences of stock sales.
Where investors are putting their ETF money
Given the popularity of ETFs among Schwab customers, the logical next question is where in particular that new money is going. Here are four trends the report identified.
First, ETF investors prefer funds that have low expense ratios. In nearly all categories of ETFs, the cheapest one-third by expense ratio brought in a disproportionately large percentage of asset inflows. Only in the study's "Other" category, which includes currency funds like CurrencyShares Japanese Yen Trust (NYSE: FXY) and asset allocation ETFs, do costs play a secondary role.
Second, investors had an on-again/off-again relationship with bond ETFs. During the early part of the year when stocks were taking a break from their rally, bond ETFs got more popular. But during the big rally from September through the end of the year, investors moved money out of bonds and into stocks.
Third, dividend ETFs and other income-focused funds accounted for more than half of Schwab's stock ETF inflows despite representing just 6% of total equity ETF assets. That focus on dividend income has made ETFs like SPDR S&P Dividend (NYSE: SDY) and Vanguard High-Yield Dividend (NYSE: VYM) extremely popular ways to participate in the general boom in dividend investing.
Finally, emerging market and commodity ETFs remained popular. Emerging markets inflows outpaced the popularity of developed-market international ETFs by a substantial margin, while commodity ETF assets grew at a much faster pace than ETF assets overall.
What's next
Of course, what happened in 2010 isn't as important for you to understand as what's going to happen this year and beyond. Yet the report's results suggest one key conclusion: ETF investors tend to follow trends rather than setting them, sticking with winning sectors until the market proves them wrong.
What that means is that trying to tap into ETF trends is likely to result in your joining a well-established herd rather than blazing your own trail. As a gauge of momentum, looking at ETF trends can be useful. But if you're looking for novel ideas, you're better off ignoring ETF figures -- until ETF investors jump on the bandwagon, at which point you'll know that your instincts were correct.
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