What was bad news for the stock market this year may prove to be good news for ETFs in 2009. As the financial markets reeled, some freshman funds that debuted in the last year, many of them commodity, currency and leveraged/inverse offerings, gave investors an alternative to business-as-usual stock and bond investments that couldn't seem to find a bottom.

New product introductions and the increasing popularity of ETFs covering alternative investments filled some of the gap left by falling stock prices and solidified these funds as investment staples rather than niche products. Assets in inverse/leveraged ETFs saw the biggest jump, increasing by 106% from the beginning of the year through the third quarter, to nearly $20 billion. Introduced about two years ago, leveraged ETFs seek to provide a multiple of the daily return of a particular index, while inverse ETFs try to replicate the inverse of an index and are typically used as a hedge. Investors looking to ride the bear market using hedge portfolios have been flocking to these products, and of the ten most heavily traded ETFs in September, three were ultra-short funds offering an inverse index return.

Assets in commodity ETFs (and ETNs) increased by 28% through September, while those in currency products increased 33% and those in fixed-income products rose 43%. SPDR Gold Shares is now the third-largest ETF in the country, having drawn net inflows of close to $3 billion in September alone, and is also one of the largest holders of gold bullion in the world.

The popularity of these new products points to a broader shift in thinking about traditional asset allocation strategies. "Until recently, most people didn't have the time or expertise needed to gain exposure to anything beyond traditional equities or fixed income," says ETF specialist Tom Lydon, president of Global Trends Investments. "Now that it's easier to diversify into alternative investments, people are shifting away from old-line asset allocation models and exploring other options."

At the end of September, 704 U.S. ETFs with assets totaling approximately $580 billion were available according to State Street Global Advisors, representing a decrease of 4.6% from asset levels at the beginning of 2008. While this marked the first time that ETF assets fell from the previous year, the drop could have been much larger considering the severe bear market during this period. The trading volume of ETFs and ETNs continued to grow, reaching 35% of all equity trading in September, according to National Stock Exchange data.

Actively managed funds, those monitored and managed by professional investors that don't track indexes, made their debut this year. The WisdomTree Dreyfus China Yuan, one of eight currency income funds, was launched in May and now has about $255 million under management, making it the largest actively managed ETF. The WisdomTree funds invest mainly in non-U.S. money market securities and offer yields that reflect foreign money market rates as well as exposure to foreign currencies. In total, WisdomTree's eight currency income ETFs (which are based on the U.S. dollar, the euro, the Brazilian real, the Japanese yen, the Chinese Yuan, the Indian rupee, the South African rand and the New Zealand dollar) have nearly $400 million in combined assets.

Still, the industry is suffering growing pains. By mid-October, 41 ETFs had closed this year as a crowded market eliminated the weaker contenders, while several "core" ETF strategies, such as international, global, dividend-focused and all-cap value and large-cap growth, experienced large drops in performance and assets.

The much-anticipated introduction of actively managed funds has proved to be a mixed bag. Amid the controversy surrounding its excessive exposure to subprime mortgage debt, Bear Stearns launched the first actively managed ETF in March, the Bear Stearns Current Yield ETF (YYY), with little fanfare, and the fund stopped trading in September. In mid-April, PowerShares Capital Management launched four actively managed ETFs, but so far, the funds have collected only a few million dollars in assets.

The roster of fixed-income ETFs expanded dramatically this year to 51 offerings with nearly $50 billion in assets, compared with only a handful two years ago. But bond ETFs came under scrutiny later in the year as credit market disruption and other factors caused their net asset values to diverge from underlying bond prices, in some cases by 15% or more. Instead of tracking indexes, as many investors expected, these funds began looking more like closed-end funds with wide discounts or premiums to net asset value.

The credit risk inherent in exchange-traded notes, a lesser-known sibling of ETFs whose returns typically track commodities or currencies, also came into focus. Instead of being backed by assets, as ETFs usually are, these notes are unsecured debt that mimics the performance of a particular index.

Investors received a cruel reminder of just how important the credit strength of the issuer is when Lehman Brothers collapsed, leaving those with stakes in its three ETNs likely to receive a fraction of what they paid.

Gary Gastineau, a principal of ETF Consultants, believes the pricing issues with bond ETFs are mainly technical in nature and "will not be a significant obstacle to growth." On the other hand, ETNs may take longer to recover. "The number of new ETN offerings has dropped sharply, and there is a lot of liquidation in existing issues. You've got falling commodity prices and credit issues coming together, and the combination is pretty toxic."

What to Look for In 2009
Emerging markets and narrowly slivered sectors of the market dominated the ETF landscape in 2007, and the offerings this year reflected people's growing appetite for investments with a low correlation to the stock market. Look for a number of trends to develop in 2009 such as more
slicing and dicing. Expect further expansion of the ETF and ETN investment universe, as well as more rules-based indexes created specifically for these products.

As of October, there were 535 ETFs and ETNs in registrations covering all areas of the market, including sector and country allocations, target dates, inverse and leveraged funds and state-specific bond funds.

David Krein, a senior director of institutional markets for Dow Jones Indexes, says ETF providers will continue to offer more exposure to far-flung corners of the globe such as Africa and the Middle East, as well as leveraged, non-dollar and inverse exposure to the commodities markets. "Advisors are looking to expand their core allocations and make more tactical bets, and new products will make that easier," he says.

Asset allocation and target-date funds. Straddling both sides of the fence, ETFs will also try to appeal to the segment of the market looking for greater simplicity. In June, TD Ameritrade and XShares began offering target-date ETFs under the TDAX banner. Both Standard & Poor's and Dow Jones have recently devised target-date indexes that could eventually become the basis for ETFs. And State Street Global Advisors has filed a series of target-date ETFs with the Securities and Exchange Commission. These would join a handful of target-date mutual funds that use ETFs as the basis for their portfolios.

ETFs in 401(k) plans. Although many believe that the biggest potential for growth in the ETF industry lies in cracking the 401(k) market, so far these retirement plans remain solidly in mutual fund territory. Those opposed to offering ETFs in this space cite the funds' administrative issues, transaction costs, bid/ask spreads and brokerage commissions as deterrents. Lydon observes that fund companies have little incentive to sacrifice the higher fees they get from mutual funds by moving participants into lower-cost ETFs. "If you take away 401(k) plans, the money going into mutual funds and ETFs is about the same, so there is a lot at stake here," he says.

Still, some signs indicate that the 401(k) market is slowly opening up to ETFs and will continue to do so, albeit slowly. In early October, WisdomTree announced a 401(k) platform that includes ETFs and other investment vehicles, saying the funds would offer investors flexibility, benchmark neutrality and low costs. Darwin Abrahamson, CEO of Invest n Retire, which specializes in 401(k) platforms for ETFs, says that new requirements by the Department of Labor mandating greater disclosure of revenue-sharing arrangements and fees will make it more likely that ETFs will be included in 401(k) plans. "There are a lot of fund expense lawsuits out there, and with these new reporting and disclosure requirements companies are going to want to look at investment options that don't have all that baggage," he says.

Actively managed ETFs hold a number of potential advantages over their mutual fund counterparts. Investment management fees are inevitable in an actively managed portfolio, but fees on the ETFs, which do not have to service shareholder accounts, would likely be lower than those in traditional mutual funds. They would probably be more tax efficient, too, and unlike many mutual funds, which require a 30-day holding period, they would have no minimum holding time.

Yet ETFs have also had a slow start, in part because of transparency requirements that compel fund managers to reveal and update portfolio holdings daily, with minimal lag time. By contrast, mutual funds usually report holdings on a quarterly basis and often do so weeks after the end of the reporting period. Although transparency requirements are a major hurdle for fund managers, mutual fund giants PIMCO, Vanguard and iShares have all filed with the SEC for approval to launch actively managed ETFs. If these are well-received, other mutual fund companies that have been sitting on the sidelines may follow their lead to remain competitive.