The Dangerous Problem Behind ETFs' Big Asset Surge

Traders work on the floor of the New York Stock Exchange
Traders work on the floor of the New York Stock Exchange

The rivalry between exchange-traded funds and mutual funds got even more heated in 2012, with ETFs winning the fight for investor assets by a landslide.

According to Morningstar research, investors put a total of $154 billion into ETFs in 2012, the biggest inflows since 2008. At the same time, investors yanked more than $119 billion out of actively managed stock mutual funds last year.

At first glance, that may seem like really good news. After all, most ETFs come with much lower fees than active mutual funds, and often, those lower costs end up improving overall returns. (In fact, Morningstar found that ETFs that invested in well-known large growth stocks outperformed their active fund counterparts by more than a percentage point in 2012 -- which may seem like a minor boost, but in fact can make a huge difference in returns over the long haul.)

The problem, though, is that investors aren't just moving their money from stock mutual funds to stock ETFs. Instead, they're making big changes to their asset allocations, and the moves they're making are a lot riskier than they think.

Selling Stocks High, Buying Bonds Higher

A closer look at the Morningstar figures reveals that only about a fifth of the money going into ETFs last year went to stock ETFs. A much higher proportion of assets went into bond ETFs, yet another sign of the continuing gravitation of investors away from "high-risk" investments like stocks and into "safe-haven" investments like bonds.

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For those who've managed to ride out the stock market waves since equities hit their 2009 lows, selling as the market hits new five-year highs has intuitive appeal. After all, the most common advice investors get is to buy low and sell high. With the market at levels it hasn't seen since before the financial crisis, current conditions appear to fit that description pretty well.

Yet even if stocks are richly valued, bonds certainly aren't the bargains that some investors make them out to be.

How Low Can You Go?

Bonds have seen 30 years of declining rates and rising prices since the high-inflation period of the late 1970s and early 1980s gave way to huge declines in inflation. Despite a recent rise over the past month, bond yields are still very close to record lows. Combined with a slow economy, upward pressure on rates has been virtually nonexistent.

The attraction to bonds comes from the fact that bond ETFs have performed extremely well in recent years. Yet even that trend appears to be slowing, as bond ETFs oriented toward the Treasury market posted more modest gains in 2012 than they did in 2011.

If the high-flying corporate and municipal bond sectors start to see their gains moderate in the coming months -- which is definitely possible given the uncertainty over the outcome of upcoming government debates on the U.S. debt ceiling and the automatic budget cuts that could take place if sequestration kicks in -- then bond ETF returns will fall dramatically and could even turn into losses for a time.

The Right ETF Move

When you're considering how to invest your money, remember that you have two separate decisions to make: Deciding whether you want to buy ETFs or active mutual funds is a completely independent issue from which ETFs or funds you'll end up choosing for your particular investing needs.

In most cases, an ETF will be less costly, more tax efficient, more transparent, and easier to understand than a similar active fund. In that sense, many ETFs are better than mutual funds.

But in order to stay on track with a long-term financial plan that takes your specific needs into account and will help you meet your money goals, you'll want an asset allocation plan that puts you in appropriate investments given your financial situation. Whether you pick ETFs, active mutual funds, or a mixture of the two, be sure to pick those with the best chance of boosting your long-term returns.

For more on smart investing:

To learn more about a few ETFs that have great promise for delivering profits to shareholders in a recovering global economy, check out The Motley Fool's special free report, 3 ETFs Set to Soar During the Recovery.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger.