It is getting slightly less crowded in the land of exchange traded funds. ETFs – baskets of securities designed to track indices and trade like stocks – have been the investment industry’s most successful product innovation in recent years, but 2008 has got off to a slow start.

According to a recent report by Morgan Stanley, there are 645 ETFs on the market today. In 2006, 154 new ETFs made their debut; last year, that number was 271. But only five new ones were launched in the first two months of this year, according to the latest statistics from the Investment Company Institute.

In spite of the slowdown in new issues, asset flows have remained relatively robust. ETF assets are about $560bn today, compared with $430bn a year ago. The market is skewed toward the larger players: the lion’s share of assets – 75 per cent – are held in the 50 largest funds, while 135 ETFs have less than $10m in assets and 80 have less than $5m.

Paul Mazzilli, director of the ETF research team at Morgan Stanley, predicts assets will continue to grow at 25-35 per cent a year, but, he adds: “The number of new listings will continue to slow because there is less start-up capital available, and most market segments are already covered. A lot of [new products] have been of the ‘me too’ variety.

“They have been brought out by fund groups that don’t have a lot of marketing clout. They just stagnate.”

But ETF innovation is hardly doomed, he says. In particular, newly launched fixed income and international funds have been successful. “Products that are timely and satisfy pent-up investor demand have done well,” says Mr Mazzilli. “The right products are going to get assets.”

Looser rules could pave way for novel approaches

The Securities and Exchange Commission’s proposed rules to loosen exemptive order requirements on exchange traded funds could reduce the time and cost of launching innovative products. Before an ETF may begin trading, it must receive a stamp of approval from the US regulator. An ETF cannot start any operations before receipt of this order.

The new rules, which were proposed in March, would allow ETFs to operate without obtaining an exemptive order. “They are a codification of what the SEC has done in exemptive applications for years now,” according to Jane Kanter, a partner in the Washington, DC office of Dechert, the international law firm. Historically, the application process has been tedious and time-consuming. The SEC reviews the submissions and then works with the investment management companies and their counsel to address any issues.

The new rules – if passed – could make for a more efficient and timely review process. “[The current process] feels like an incredible waste of time and effort especially in terms of getting a boiler plate ETF through,” says Ms Kanter. “For people who want to come to market with an ETF [the new rules] will streamline the process. It will take away five to six months of time, so you can focus on getting your funds launched.”

A speedier process could also result in more pioneering, inventive products. “The new rules will lead to greater innovation because fund providers will spend less time on the bureaucracy and more time on the creative aspects of creating a fund,” she says.

Some in the industry have expressed concerns that altering the requirements could mean that the ETF landscape will become even more jam-packed with newcomers. Ms Kanter is not worried. “The market will take care of the excess,” she says. “It’s very simple: if you come out with something that’s not attractive, people will not buy it.”

Take, for instance, WisdomTree’s India ETF – the first such fund to cover the country. The fund, which is weighted by earnings, launched in February, and now has $163m in assets.

State Street Global Advisors has done well with global, fixed income-based ETFs. Its International Government Inflation-Protected Bond ETF, which includes 120 inflation-indexed bonds from 18 developed and emerging countries outside the US, launched in March, and has $72.5m in assets.

SSgA launched an international treasury bond fund in October that has also seen strong flows. The ETF, designed to provide low-cost access to international fixed income – an asset class that historically has had a low correlation with the US equity and bond markets – today has $750m in assets.

“When we looked at the investment landscape, we could see that investors, one, want to diversify away from the dollar and, two, are scared about inflation,” says Jim Ross, a senior managing director at SSgA.

Barclays Global Investors has also made a splash in fixed income. Last September it introduced the S&P National Muni Bond ETF, which gives investors an opportunity to place low-cost bets on the $2.400bn US municipal bond market without directly owning individual bonds. It has seen steady flows, and today boasts about $562m. Meanwhile, Barclays’ California Muni Bond ETF – launched in October with about $40m in assets – today has $70m.

“There has been a growth in investor awareness and adoption of these ETFs,” says Matt Tucker, head of fixed-income investment solutions for BGI’s iShares business. “In some ways it was a good time to launch the product. Investors view the ETF as the more transparent, less risky way to access the market.”

Northern Trust, one of the biggest institutional asset management companies in the US, is also getting in on the action by introducing a new line of international ETFs. In April, it launched six funds that track some of the world’s best-recognised equities indexes. The funds include the Hong Kong Hang Seng Index Fund and the UK’s FTSE 100 Index Fund.

According to Steven Schoenfeld, the company’s chief investment officer, these represent the “crown jewels” of indexing. “In devising our entry strategy, we wondered what we could bring to the market that investors would accept and applaud. It doesn’t make sense to burden the ETF infrastructure with another ‘me too’ product,” he says. “We’re bringing global markets to the US time-zone.”

Northern Trust has also registered with the Securities and Exchange Commission to launch similar ETFs from other large, developed markets such as Italy, the Netherlands and Singapore, as well as medium-sized markets such as Belgium, Portugal and the Republic of Ireland, and emerging markets including South Africa and Thailand.

But product innovation goes beyond the realm of fixed income and international. ProFund Advisors, a money manager that has carved a niche in the fund management industry by providing mutual funds with leveraged short and long attributes, in March brought out two ETFs that enable investors to go long or short on the telecoms industry.

Rydex Investments also plans to introduce new inverse and leveraged funds later this year. “Because of existing market conditions people have gravitated toward the inverse funds,” says Tim Meyer, managing director of Rydex ETFs. “But there are always going to be some sectors that start to perform, and we could see assets shift from inverse to long leverage.”

Other fund companies are launching industry-specific ETFs. Claymore Securities last month launched an ETF designed to mirror the MAC Global Solar Energy Index, which tracks companies that produce solar power equipment and services. The ETF now has assets of more than $50m. Most of the portfolio – 72 per cent – comprises companies outside the US, with China and Germany the biggest regions represented.

Christian Magoon, president of Claymore’s ETF division, says the fund should appeal to retail and institutional investors.

“Retail investors and financial advisers are looking for a diversified approach to the next generation of energy, and, from an allocation perspective, they want a hedge on their fossil-fuel stocks,” he says. “Institutions and hedge funds will use the ETF as a hedge for individual solar stocks in their portfolio or to make a solar bet.”

Actively managed ETFs are also new to market. In April, Invesco Powershares launched four funds that each involve some element of active management.

The Alpha Q invests in a portfolio of 50 Nasdaq-listed securities, and is benchmarked to the Nasdaq 100. The Alpha Multi-Cap is benchmarked to the S&P 500. The other two funds – the Active Mega-Cap and the Active Low Duration Fund – are sub-advised using quantitative models.

The Active Mega-Cap invests mainly in blue-chip, large-capitalisation companies, and is benchmarked to the Russell Top 200 Index. The Active Low Duration Fund invests in a portfolio of US government and corporate debt securities. The fund is benchmarked to the Lehman Brothers 1–3 Year US Treasury Index.

Many observers expect more actively managed ETFs will arrive on the market in the coming months. In fact, several fund providers have active funds in registration with the SEC.

Richard Ferri, author of The ETF Book and founder of Portfolio Solutions, the Michigan-based investment management firm, is sceptical of these new, innovative products. “Whether or not these funds are any good, it’s not a big deal,” he says. “It’s about marketing; it’s about creating excitement.”