Well-heeled individuals are fueling the explosive growth of the exchange-traded fund, now a $700 billion business that began in the early 1990s.

"High-net-worth individuals are certainly embracing ETFs," says Robert Testa, an analyst with Cerulli Associates. The Boston-based consultant is studying the growth of the ETF, which has seen an explosion in assets for about a decade. Market observers say the market's woes in 2008 increased the ETF's popularity. That's because well-heeled investors have become more risk adverse.

"Another factor that could be driving some of the ETF usage is a move toward more transparency and lower costs to clients that resulted from the market downturn," according to a recent Cerulli Associates report.

The staggering losses in client portfolios in 2008, the report continued, have led high-net-worth investors to use more ETFs. They offer "inexpensive exposure to market segments that are typically expensive to manage actively, including international and emerging markets," according to the fourth quarter edition of Cerulli Associates' Managed Accounts, an internal publication.

How did ETFs become popular with rich individual investors?

The ETF portfolio was almost solely an institutional investment, used by hedge funds and endowments in the early 1990s when it was introduced. But now it has become a favorite of the well heeled and their advisors, who have many more ETF options.

"It's not surprising to see its popularity with the rich and their advisors. This has been going on for a while now," says Scott Burns, director of ETF analysis at Morningstar.

ETFs, he notes, generally have considerably lower expense ratios than conventional mutual funds. "The price advantage is a big issue with advisors and their rich clients as are the tax planning features," he says.

Surveys show the separately managed account and the ETF have become the recent favorite investment tools of high-net-worth investors, Burns says. The typical investor in this group, he adds, generally has at least $10 million of investable assets. Many of these people, observers say, felt they were burned by conventional funds in the 2008 blowup.
"In an era of renewed emphasis on risk management, ETFs are a good fit because of their transparency," says Carl Resnick, a managing director and portfolio strategist for Rydex/SGI, one of the smaller players in the ETF business with some $6 billion in assets.

Rydex is focusing on selling ETFs to rich individuals and their advisors-clients who typically have between $100 million and $1 billion to invest, Resnick says. The specialization of ETFs is one reason why high-net-worth investors are now buying the product, he says.

For example, recent fears over the debasement of the dollar have become a theme with Rydex ETF's offerings. "Our CurrencyShares would be attractive to high-net-worth individuals," Resnick notes. Many of these sector ETF offerings weren't available a year or two ago.

A Barclays' portfolio manager notes that there are now about 900 ETFs and many more are in the pipeline.  Sean Crawford is a portfolio manager with Barclays Wealth, Americas, which was formerly a unit of Lehman Brothers. Barclays Wealth's Tactical Allocation Beta Portfolios, a new program that works with advisors and requires clients have at least $10 million in assets, uses ETFs because of their growing specialization, he says.
"The ETF is increasingly becoming more and more targeted so you can actually get the recommended allocation in a portfolio," Crawford says.  
"From my perspective of building a portfolio, there's a lot more ways of implementing our tactical recommendations than there were just 12 months ago," Crawford says.

Using ETFs, it becomes easier to overweight a sector, Crawford says. He argues that the ability to trade and value the vehicle throughout the day-not just at the end of the day-are also why he is often using this investment vehicle.
In 2002, ETFs only had some $100 billion in assets under management. Then ETFs took off. Today that amount of ETF assets under management is some $700 billion, according to Morningstar.

What's feeding this growth?
Cindy Zarker, director of retail asset management for Cerulli, says initially institutional investors such as pension funds and endowments built the ETF business. But over the past few years, buying patterns have changed and institutions only hold about a third of the assets. Individual investors now own 66% of the assets, according to Zarker.

Another reason for the ETF's success is that they are increasingly offering individuals exposure to exotic instruments, such as currency plays and commodity options, that were previously difficult for the retail investor to obtain, Zarker says.
The ETF sponsor heavyweights who are playing on this trend are Barclays, State Street Global Advisors and Vanguard, which together own 85% of the $700 billion ETF market, according to State Street Global Research.

Advisors and their clients, meanwhile, are attracted to the ETF's liquidity, transparency, expanded product line and cost.
"This is a cheap way to obtain beta when you're designing a portfolio," Burns says.

"Barclays is a leader because they have heavily invested in educating investors and individuals," Zarker says. The education push, which is not limited to Barclays, appears to be goosing up sales.

ETFs have had $8 billion or more in net inflows so far this year. Six of the seven ETF groups charted by Morningstar have gained assets this year through the end of October. Taxable bond, international stock, commodities and alternative investments have been the biggest gainers. U.S. stock was the only loser, according to Morningstar. Resnick contends there's a greater interest in the ETF among the well heeled than a decade ago. The product's portfolio, unlike its mutual fund cousin, is easier to understand. ETF portfolios are constantly disclosed.

By contrast, traditional mutual funds show positions once a quarter, Resnick notes. And, by the time investors receive those reports, some positions usually have been sold. That's not a problem with ETFs, which industry observers believe is one factor attracting assets from investors who were burned in the meltdown.

"It's a risk management issue," says Testa of Cerulli Associates. "You get daily pricing and can see what's in the ETF portfolio. In the market meltdown, many advisors with mutual funds weren't aware of what had gone on until they got their quarterly reports," Testa says.

Is there a potential downside to ETF portfolios?
The ETF is still relatively new and many ETFs have almost no track record, experts note. That spooks some investors and their advisors, which owns 85%of the $70 billion ETF worth, who keep client assets in mutual funds out of habit.
"There's lots of educating we must do," Rydex's Resnick concedes.

Some investors understand the vehicle but are troubled by the lack of long-term numbers. Others investors prefer active management and generally shun passive instruments such as ETFs, although experts note that producers have started to introduce actively managed ETFs.

"There's a comfort level with traditional funds and some have never dealt with ETFs before and are hesitant," Resnick explains.

Even sponsors are sometimes feeling their way around the ETF market.

For example, Rydex, which has about ten ETFs and some $6 billion in assets under management, has no actively managed ETFs and no immediate plans to offer them.

"We're still looking at that. There's very little record of how actively managed ETFs perform," Resnick says. "My personal opinion is that actively managed ETFs are just too new."    

Catching The Wave
How quickly has the ETF business built up?
At the end of 1993, there was only one ETF on the market, with assets of $464 million, reports Richard A. Ferri in The ETF Book. By 1997, ETF assets totaled some $6.2 billion, writes Ferri. By 2002, ETF assets were still only $100 million, according to Cerulli.
But since 2004, ETF assets have been growing at a yearly rate
of 399%, the consultant reports. Continued strong expansion is expected for the industry, most players and observers agree.
"Barring a market meltdown, I can see [the ETF market] becoming a trillion dollar business by 2010," says Cindy Zarker, director of retail asset management for Cerulli.
Ferri, the founder of Portfolio Solutions, writes in his book that ETF assets could reach $2 trillion over the next decade-an assessment shared by Morgan Stanley in a recent report. Ferri also says that ETF assets might equal mutual fund assets in a decade or so and that high-net-worth investors will be a big part of the growth.