It has been 13 years since State Street Global Advisors introduced the first ETFs, tracking the performance of the S&P 500 index, fondly called "spiders" for S&P’s Depository Receipts (SPDR). Quietly, this investment vehicle developed into many shapes and sizes, spanning all asset classes, industry groups and global regions. But it wasn’t until after the bear market of 2000 to 2002 that ETFs gained notable recognition. Investors began to realize that few managers of actively managed mutual funds actually beat their market benchmarks over time.

The most compelling reason for the popularity of ETFs is liquidity.

Investors like such benefits as low fees, tax efficiency and 24/7 disclosure of the stocks in the underlying index, but it appears that the most compelling reason for the popularity of ETFs is liquidity. At least one-third of the money in ETFs comes from institutions—pension funds, hedge funds, even actively managed mutual funds—and these investors look at ETFs as a way to quickly go in and out of asset classes.

Swapping conventional mutual fund assets for ETFs is a growing trend among institutional and individual investors, and there is still plenty of room to grow. Total assets in the approximately 430 ETFs that exist in the United States amount to $435 billion, while mutual funds comprise about $10.1 trillion in domestic assets. Industry forecasts expect ETFs to hit $1 trillion in assets by 2010.

However, as ETFs grow, a chicken-or-egg question looms large. As competition intensifies, ETF providers are turning to creative indexing strategies, such as cap-weighting, equal-weighting, fundamentally weighting and dividend-paying indices, as well as manufacturing new indices for the sole purpose of wrapping ETFs around them. Among the large institutions that actively manage ETFs in registration are Bear Stearns and Managed Shares, cofounded by Gary Gastineau, who was instrumental in the introduction of many popular ETFs at Nuveen Investments.

By Any Other Name
But if an institution actively manages an ETF, doesn’t it cease to be an ETF? The way I see it, a fine line of demarcation exists. When managers pick the stocks in an index prior to creating the index for an ETF, it is still an ETF if it meets the following three conditions:

1. There is a highly disciplined set of criteria regarding which stocks qualify for the index and which ones do not. If any wiggle room exists in the criteria, it is not an ETF.

2. Investors can go online at any time of the day and see the holdings in real time. By definition, ETFs are wholly transparent, while mutual funds must disclose their holdings only every 90 days.

3. The management fees are no more than 75 basis points.

Investors considering an actively managed ETF should first ask: What motivation does a big-time money manager have to create such a fund? The money manager will have higher expense ratios than with a fund tied strictly to an index, but lower management fees. The only reason a major institution would do this is to capitalize on a hot trend, especially if the institution has mutual funds that have been ho-hum performers.

On the other hand, it is too early in the game to dismiss the new entrants that are true ETFs. Mutual funds went through a similar growth spurt in the early 1980s, when new sector funds appeared every week amid criticism that they were mainly marketing ploys. Now some 300 to 500 mutual funds either close down or merge into stronger funds each year. We are at least three to five years away from that kind of free-for-all among ETFs. They are not supposed to be flashy and innovative, but they can provide a sober-headed way to obtain exposure combined with diversification in a booming sector, such as cancer-related healthcare, clean energy or Asian small caps. Bring them on.

Tom Lydon is editor of ETFtrends.com and president of Global Trends Investments in Newport Beach, Calif.