ETFs Gather Smart Money and Hot Money -- Which Are You?

(MoneyWatch)  Reuters blogger Felix Salmon wrote a rather lengthy piece last week about a topic I touched upon earlier this year: investor cash has been pouring out of actively managed equity funds and into index funds.

Noting this trend, Salmon writes "in terms of long-term investments, people are still massively overweight actively-managed strategies. But they're sensibly rotating out of those funds, and into passive ETFs."

That's undeniably true. The tremendous growth of index mutual funds and ETFs undoubtedly indicates that a growing segment of investors are coming to appreciate the logic of indexing.

Why? It's impossible to say for certain. But if I had to guess, I would say that the past decade in general -- and the most recent bear market in particular -- has convinced a growing number of investors that their fund managers have been selling them a bill of goods.

One of the long-touted benefits of active management is the manager's flexibility. They're able to go to cash during bear markets, shielding their investors from the market's worst declines. They're able to separate the "good" stocks from all of the "bad" stocks contained in the index, adding value during largely barren "stock picker's markets."

But during the recent market turmoil, those claims were severely tested, and found wanting. Realizing this, more and more investors are throwing in the towel on active management and turning to index funds.

But Jack Bogle shouldn't embark on his victory lap just yet. Because I think that there's another factor behind those numbers that many observers -- including Salmon -- are overlooking, and it has to do with the role of ETFs in that growth.

As Salmon noted, net flow into ETFs over the past year-and-a-half is roughly double the net flow of index mutual funds, which makes what would be a steady stream of cash out of actively managed funds and into index funds look like a deluge. But if you scratch the surface of those ETF flows a bit, it's hard to make the case that they're being bought by investors who are embracing the traditional model of indexing that has proven so successful.

According to data from Strategic Insight, the five ETFs that have received the largest net cash flow over the past one-and-a-half years are, in order, Vanguard's Emerging Markets ETF, the iShares Emerging Markets ETF, ProShares UltraShort S&P 500 ETF, iShares S&P Preferred Stock ETF, and the ProShares Short S&P 500 ETF.

Together, these five funds have taken in nearly 40 percent of all ETF net cash flow in that period -- or nearly $0.40 of every $1 that has gone into ETFs.

But in looking at that list, one would be hard-pressed to make the case that any of those funds would play a leading role as part of a portfolio of broad-market index funds that is bought to be held long-term. Indeed, it would be much easier to believe that they're being bought by investors using the same mind-set that led so many billions of dollars to flow into technology funds at the turn of the century.

Are investors getting smarter, eschewing their misplaced and costly faith in active management in favor of the indisputable benefits of a low-cost indexed approach? Yes, some of them are, and their ranks are growing by the day. But that trend is likely not nearly as large as it might first appear to be, inflated as it is by investors using ETFs to pour into the hot sector of the moment.

Salmon ended his piece by writing that if a fund manager's "business model is based on managing [actively managed] domestic mutual funds and getting a steady flow of new investments, you're not going to find life easy going forward."

I agree 100 percent. But unfortunately, I think that a certain segment of investors who are seemingly becoming smarter about investing are simply using new products to make the same dumb mistakes all over again.