A Year to Remember for Exchange-Traded Funds

How'd They Do?
Among ETFs, performance mirrored that of the traditional fund universe. Value-oriented ETFs beat growth-leaning ones, though both styles gained. Likewise, small-cap ETFs beat large-cap funds, and international offerings beat domestic vehicles. ETFs with exposure to emerging markets in Asia, Eastern Europe, and Latin America did well. Consumer, industrial, energy, and real estate sector ETFs also rallied. Anything tracking technology, semiconductors, and large-cap pharmaceutical stocks lagged.

My, How They've Grown
The ETF industry, which remains small compared with the $7.9 trillion traditional mutual fund business, continued to expand. Firms launched 35 new ETFs 2004, the most in five years and the second-largest number of new ETF offerings ever.

Vanguard launched more ETFs than anybody in 2004, and most of the 18 new Vipers it rolled out are now the cheapest ETF options in their respective categories. Industry leader Barclays Global Investors introduced 13 new ETFs, including  iShares FTSE/Xinhua China 25 Index . But State Street Global Advisors stole most of the attention with its new  StreetTracks Gold Shares . The gold fund gathered more than $1.5 billion in assets and became one of the 10 most actively traded ETFs after its November launch. The China 25 ETF was a distant second among new funds in terms of net assets, followed by Vanguard REIT Index Vipers . Be wary of the excitement, though. You can argue for making room for a small amount of real estate, gold, and even China in a diversified portfolio, but each of those areas looks pricey after rallying in recent years.

Turn up the Volume
The two biggest ETFs-- Nasdaq 100 Trust Shares and  SPDR --still account for nearly three fourths of average daily ETF trading volume, according to current Morningstar data. Yet activity in a number of sector, regional, and single-country ETFs increased in 2004. For example, volume in the iShares Dow Jones U.S. Real Estate and iShares S&P Global Energy Sector each increased more than 85%. Likewise, activity in iShares MSCI Austria Index  and  iShares S&P Latin America 40 Index  each jumped by more than 70%. It's probably no coincidence that these funds posted strong gains in 2004.

What's Next?
A number of new funds should hit the market in 2005, including socially responsible ETFs from iShares and Powershares, and exchange-traded share classes of Vanguard's European Stock , Pacific Stock , and Emerging Markets Stock  index funds. Barclays also could launch its own Gold ETF, which has been in registration with the SEC for about a year, to compete with StreetTracks.

You can also expect more talk about other commodity-based and actively managed ETFs. Don't expect to be able to trade them in 2005, though. It took the SEC nearly a year and a half to approve the first Gold ETF and it's likely to take a long time to get the okay for a commodity ETF tracking oil or other natural resources. Similarly, regulators are likely to take a good, hard look at actively managed ETFs--if and when one ever seeks approval. In the case of actively managed ETFs, it's also still not clear why anyone would want one. A large part of ETFs' appeal is they are not actively managed funds, which, on average, tend to lag their benchmarks over time and charge too much money.

Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares.