Why Exchange Traded Funds Are Gaining Steam as CFO Investment Tools

Exchange traded funds, or ETFs are on a tear these days. Some $95 billion flowed into U.S. ETFS during the first eleven months of 2011, Deutsche Bank reports. That compares to $34 billion that went to mutual funds. And the researchers predict 15% to 20% growth this year.

ETFS -- “basically mutual funds that trade like stocks,” in the words of Scott Burns, director of ETF research with investment research firm Morningstar Inc. -- consist of a group of securities that trade throughout the day. Mutual fund transactions, in contrast, are completed at the end of each day.

ETFs can be limited to a specific sector, like commodities, or type of investment, such as government securities. Many ETFS try to replicate a particular security index. For instance, Invesco’s PowerShares Dividend Achiever Portfolio normally invests at least 90% of its assets in the dividend paying common stocks comprising the Broad Dividend Achievers IndexTM.

An Option for Corporate Investors? Part of the growth in the ETF market is due to the expanding number of products across different ranges of asset classes, says Ed McRedmond, senior vice president of institutional and portfolio strategies with Invesco PowerShares, Invesco’s ETF arm. Over the past few years, CFOs and other corporate investors have been able to more easily find ETFs that meet their investing parameters.

In addition, many investors are looking for low-cost products, says Morningstar’s Burns. ETFs tend to have low expense ratios.

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To be sure, the overall volume of ETFs still pales in comparison to that of mutual funds. According to statistics from the Investment Company Institute, at year-end 2011, the amount of assets in U.S. ETFs totaled $1.05 trillion, or about one-tenth the $11.6 trillion in mutual funds.

Still, given the growth in ETFs, it’s worth asking: Are they viable investments for corporate portfolios?

At the moment, “it’s hard to get a sense on corporate use of ETFs,” according to McRedmond. That’s because the data submitted to the Securities and Exchange Commission on ETF investors comes via the SEC’s Form 13F. These reports are filed by most institutional investment managers with $100 million or more in assets under management.

When a corporate holder does show up in the 13F as an ETF holder, it generally is in relation to the company’s retirement funds, rather than, say, a treasurer investing the company’s cash balances, McRedmond says. For example, some ETFs are appearing as investment options in 401(k) plans, he adds. “That’s an area where we’re seeing ETFs get a little more traction, in addition to corporate pension fund portfolios.”

That’s not to say companies couldn’t use ETFs in other ways. Thomas Warschauer, an emeritus professor of finance at San Diego State University, has studied ETFs, although primarily as an investment for individuals. However, he identified several instances in which ETFs may make sense in corporate portfolios. One would be when a company is considering an acquisition in another industry; it could buy an industry-related ETF to hedge against value increases during negotiations. Another example: a company is developing a new technology, and the raw materials it needs will impact the price and competitiveness of the final product. However, no futures contracts are available for the materials. To hedge its expenses, the company could invest in an ETF that focuses on the materials.

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ETFs Versus Mutual Funds ETFs offer several potential advantages over mutual funds. One is transparency. “You know your holdings each day,” McRedmond says. In contrast, the holdings within most mutual funds typically are disclosed on a quarterly basis. Many ETF investors found this information critical during the financial crisis in 2008-2009, as they could quickly determine their exposure to companies in trouble – say, AIG.

Also, ETFs can be bought or sold throughout the day, while transactions in money market funds are completed at the end of the day. Often, it’s during the last hour or so of the day that markets run or drop, Burns says. “With market volatility, transacting at 10 A.M. has some value.”

That’s not to say that ETFs have no shortcomings. When buying or selling an ETF, you’ll typically incur a commission, which wouldn’t come into play in a similar mutual fund transaction, McRedmond says. Even so, it’s possible to find some brokerage firms that charge less than $10 per trade, as well as some offering zero-commission ETF trades.

In addition, a few ETFs are only thinly traded, Burns says. A corporate treasurer or CFO would want to check that a planned trade doesn’t come close to (or exceed) the average transaction daily volume of the ETF they’re considering.