During the next four years, exchange-traded funds should continue to have the fastest growth rate among the three major fund types used by retail investors, according to a new study.

That follows similar growth patterns forecasted in the past for ETFs over active mutual funds and index mutual funds. The latest, done by Financial Research Corp., also projects that by 2012, ETFs will represent 6.8% of the retail investment marketplace's total assets.

That may not seem like a huge number, but keep in mind that would represent the first time that ETFs eclipse index mutual funds in terms of market share among all major investment product categories.

Active funds will also drop to 55.1% market share, down from 61.1% at the end of 2007, and 68.1% in 2002. (In 2002, only 2.1% of the investment market was represented by ETFs.)

While 6.8% might still seem fairly small in comparison to the longtime majority figure for active funds, there are some realities of the asset management industry that dictate ETF gains against active funds will continue to be a gradual success story.

Kristin Adamonis, senior editor at FRC and author of the study, said, "The asset base for actively managed funds is so huge that I don't think even in 10 years any product will overtake it in total market share. Chipping away at market share will be the method."

There is also an important caveat to the data. ETF growth in net sales and total assets is both an institutional and retail story.

The data for ETFs cannot be separated into retail and institutional (e.g., retail distribution platform use of ETFs versus mutual fund manager, small pension plans and hedge funds' use of ETFs). Mutual funds, on the other hand, are primarily retail investments, though many mutual funds do offer an institutional share class that can be used by small institutions.

In the end, comparisons between ETFs and mutual funds are less than apples-to-apples when looking at net sales to retail investors. Adamonis said FRC had used "conservative" numbers in making its projections.

Still, the ETF numbers are very healthy, and FRC expects them to remain that way through 2012.

Since 2004, ETFs have been grabbing 20% per year in fund industry net sales, as compared to the figures for active and passive mutual funds. Beginning in 2007, annual net sales of ETFs first began to rival the sales of actively managed mutual funds, FRC data shows.

A snapshot of 2006 and 2007 shows how quickly ETFs have assumed a higher profile among investors, versus the net sales rate of the mutual funds:

*Retail mutual fund net sales versus total (institutional and retail) ETF net sales

ETFs spike of 16% in net sales from 2006 to 2007 is an important growth story, relative to the net sales rates for active and passive mutual funds.

Also eye-opening is the total passive investment net sales—ETFs and index mutual funds—versus active mutual funds in 2007. A majority of net sales for the year were garnered between ETFs and index funds relative to active managers. Just a year earlier, active funds dominated 67.5% of net sales among the three fund structures.

Active funds' drop of more than 20% in net sales year-over-year is eye-popping. However, maybe most impressive is the fact that between 1999 and 2007, there was no year before 2007 in which active funds did not have a majority of net sales among the three fund types, according to FRC data.

This year, in particular, with active funds hit by massive redemptions, the steady growth story of ETFs has become even more pronounced. In fact, FRC is predicting that ETFs will surpass mutual funds in annual net sales for the first time by year-end.

September and October redemptions have been a big part of that net sales story this year: $61 billion came into ETFs from retail and institutional investors during September and October, while $126 billion came out from traditional mutual funds.

The real story, though, is the long-term growth potential for ETFs as a result of the changing nature of retail portfolio construction, dovetailing with the widespread adoption of ETFs.

FRC set out to specifically examine which investment structures would benefit the most from the separation of alpha and beta in the retail portfolio (also known as the core-satellite approach).

Bone Of Contention 

This trend has become more prevalent with the inability of active funds to prove their worth performancewise versus passive counterparts. Paying a lot in fees for a little alpha in core equity areas has become a bone of contention for most advisors and investors.

The core-satellite approach allows advisors and investors to use cheap, passive investments—both ETFs and index mutual funds—for core beta holdings. The passive core of the portfolio is then surrounded by active managers in alpha-generating niches of the market, where paying for performance makes more sense.

Adamonis said the study, which includes a survey of financial advisors, showed ETFs as being the biggest threat to mutual funds in retail portfolios. No surprise there, but what was most interesting was that advisors said ETFs were not just a big threat in the big beta areas, such as large-cap core, where FRC expected the core-satellite approach to favor ETFs, but across all the niche sector asset classes.

"ETFs are going to encroach on fund territory across the board," Adamonis said.

This also partially explains why ETFs have been gaining ground relative to index mutual funds, and why FRC expects that trend to continue. Product development among passive ETFs has exploded into almost all sectors of the market, whereas index mutual funds are still typically in the core asset classes.

What's more, among the more than 300 advisors surveyed by FRC, 71% were using ETFs, which was a 50% spike from the same 2005 survey group, when only 25% of advisors said they were using ETFs.