The current financial crisis is dramatically reshaping the exchange-traded fund (ETF) industry. Slumping global markets forced total U.S. ETF assets under management down 13% at the end of 2008 versus 2007. Meanwhile, the pace of new ETF launches has slowed, with 58 ETFs liquidating over the course of 2008.

But these negative data points belie the fundamental strength of the ETF market. Take, for instance, assets under management. While U.S. ETF assets are down 13%, that only reflects the global market slump, not investor demand for ETFs. Worldwide, investors actually poured more than $268 billion in net new cash into ETFs in 2008. Over the same period, traditional mutual funds experienced $320 billion in net withdrawals.

It’s a recurring trend: during times of crisis, ETF assets rise. In the last period of substantial market movements—2000 to 2002—assets jumped 56%, according to Morgan Stanley, as investors turned to ETFs and index-based strategies in the wake of the Internet bubble. The industry saw a similar jump during the mutual fund market timing scandal of 2003, as investors embraced the transparency, low costs and reliability of ETFs.

The industry has shown other signs of strength recently, as well. As shown in the adjoining sidebar, ETFs are occupying an increasingly central place in the trading community. ETFs’ share of total dollar trading volume in the United States rose from 25% to over 40% during the heart of the financial crisis, and appears to have settled at a new “base” level of around 35% of total trading. On most days, ETFs occupy four or five of the “top 10 most traded” lists in the United States.

In other areas, the ETF industry has been maturing. As mentioned, ETF companies liquidated 58 ETFs in 2008, a record for the industry. Most of the closings have been in niche products, or in areas with substantial competition launched during the boom of 2006-2007. More closings are likely: as of December 31, 2008, there were hundreds with less than $10 million in assets—candidates to be shut down if assets don’t grow.

Just because some funds are closing, however, does not mean the industry is shrinking. Companies continued to launch ETFs in 2008, with 472 exchange-traded products launched worldwide. These funds have opened up new areas such as frontier markets and international Treasury Inflation Protected Securities (TIPS) for the first time. More than 600 ETFs are in registration worldwide.

Some interesting trends are lining up in 2009, starting with the entry of large mutual fund companies into the ETF space. PIMCO, the world’s largest bond manager, has filed papers to launch a family of ETFs in 2009, and rumors have circulated that Eaton Vance and other titans of traditional mutual funds may file their proposed products soon. In a way, it’s not surprising: according to the ICI, ETFs’ share of total assets under management rose from just 1% in 2000 to 7.6% by fall 2008. In the face of such powerful growth, no one wants to get caught on the sidelines as that number goes to 10%, 20% or even more.

(Data courtesy Index Universe, BGI, March 2009)

ETF Trading at Record Highs

There’s no doubt that the second half of 2008 was an anxious time for institutional and individual investors alike. With record volume and volatility, investors had to think on their feet, evaluating their exposures in a market losing 10% one day, and gaining it back the next.

Exchange-traded funds have been the vehicle of choice in this market.

This trend toward ETF use was pronounced on some of the most volatile days this past fall. On September 29—the day the Dow Jones Industrial Average fell 778 points on the House of Representatives’ initial rejection of the credit crisis bailout plan—ETF trading was near an all-time high, at 35.7%. Just one month later, on October 29, the Dow rallied 889 points. And with this phenomenal 10.9% gain came an even bigger reliance on ETFs as the trading vehicle of choice, reaching nearly 40% of trades. Trading for the month of November averaged over 40%.

While it’s not the case that every big swing in the Dow equals a big jump in ETF volume, it is evident that ETFs have become the default trading vehicle for a significant group of active traders, retail and institutional.