Imagination is the only limit

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Want to make a bet on silver? How about aerospace? Or perhaps you fancy alternative weighting techniques? With nearly 200 exchange-traded funds (ETFs) on the market holding about $341bn in assets, almost anything is possible.

And the possibilities are multiplying. Even investors who consider themselves au courant with all the latest hot products, can find it tough to keep tabs on exchange-traded funds. The number of ETFs – baskets of securities designed to track indices and trade like stocks – is rocketing as each week newer, zippier products come to market.

According to Financial Research Corporation (FRC), the Boston-based data
company, 65 ETFs have launched already this year and 52 launched last year. To put that in perspective, the number of ETF launches in 1996 was 17.

According to Dan Dolan, director of wealth management strategies for the Sector SPDRs Trust which is managed by State Street: “In the beginning ETFs were positioned as an alternative to mutual funds, but a current trend is using an ETF as a pure stock substitute, eliminating single stock risk.

“In other words: why just buy Exxon, when I could invest in an ETF of oil and gas producers and spread the risk?” Mr Dolan points out.

Dan Culleton, lead ETF analyst at fund data company Morningstar, says: “There is a frenzied pace of growth because ETFs are the fastest growing niche of the mutual fund market, which is a very mature market. Providers want to get in on the action and solidify their position. There is also a rising interest in delivering new ways to access alter­native asset classes.”

As ETF providers explore initiatives for the second half of the year and beyond, investors should expect a run of new products. “The trend is to get more specific, more narrow and more esoteric,” says Mr Culleton. “The types of products being offered are limited only by the provider’s imagination.”

Barclays Global Investors – the biggest ETF provider in the US – plans to introduce several products that cover hard-to-access asset classes, such as commodities and fixed income. BGI is the only ETF provider to offer fixed income funds, although the Vanguard Group also has a fixed income ETF in the works.

“If you are a financial adviser who likes to use ETFs because of their flex­ibility, missing out on fixed income is a big problem,” says Tom Taggart, a managing director at BGI. “It is an asset class of great interest to financial advisors, and that is our sweet spot.”

In addition, he says, Barclays is focused on expanding its commodities line; iShares already offers a gold ETF and recently launched a silver trust. Mr Taggart says BGI has registered with the Securities and Exchange Commission for several new commodity-based ETFs, which should begin trading by the end of the year.

Vanguard says that in addition to new fixed income funds it is considering introducing new international funds. Vanguard offers several international ETFs, including European, Pacific and emerging markets. “There is continued demand at the regional level, rather than just individual countries,” says Noel Archard, head of ETF product management at Vanguard.

Providers are also increasing sector and sub-sector lines. The first ETFs mimicked big stock indices such as the Standard & Poor’s 500, and ETFs based on the S&P 500, Nasdaq 100 and Russell 2000 continue to be the most heavily traded stocks each day in the entire US stock market. These were similar to traditional index funds but had lower fees and were more tax efficient. As they grew in popularity providers started expanding beyond indices to narrower segments of the market, giving investors ways of backing sectors, geographic regions or currencies.

Mr Dolan of State Street says investors should expect to see “a greater number of sector products that thinly slice industries”.

State Street has filed for 17 new ETFs that specialise in such industries as aerospace, leisure, computer software, computer hardware, and healthcare equipment.

State Street is not the only ETF provider introducing sector products. First Trust Advisors last week launched the Dow Jones Internet Index, which tracks 40 of the largest and most actively traded US-based internet companies. The index, which was launched at the height of the dotcom bubble in February 1999, is designed to measure companies whose primary business generates at least 50 per cent of its revenues from the internet.

Other ETF providers are coming out with indices that incorporate alternative weighting and quantitative strategies. Earlier this month WisdomTree introduced 20 ETFs that track dividend indices – 18 of these US and international indices are weighted based on the total cash dividends comp­anies pay; two are based on dividend yield.

PowerShares, meanwhile, plans to introduce at least 31 ETFs this year – 10 of which are based on the “fundamental indexing” methodology of Robert Arnott, chairman of Research Affiliates. One of these will weight mid- and small-cap stocks based on revenues, book value, cash flow, and dividends instead of by market capitalisation. The other funds will apply the same weighting scheme to stocks in sectors including basic materials, industrials, consumer goods and financials.

Like the WisdomTree funds, they are based on the theory that orthodox indices geared to market capitalisation are automatically biased in favour of over-valued stocks. “PowerShares is based on indices that have intelligent design,” says Bruce Bond, president and CEO of the company, which currently has 37 ETFs on the market but is still a relatively small player in the industry. “The reason we are introducing these funds is to provide a better weighting structure rather than just market capitalisation which has a growth bias.”

Some future ETFs will also use sophisticated trading techniques. Both ProFund Advisors and Rydex Investments – two money managers that have already carved out a niche in the fund management industry – plan to launch leveraged ETFs. While these funds are predominantly aimed at hedge funds and big institutions, they will enable bullish retail investors to make big bets on traditional stock indices while allowing bearish investors to make money during market downturns.

Industry experts are divided over how much longer this product innovation will continue. David Haywood, director of alternative investment research at FRC believes the market is close to saturation. “We are quickly reaching the point where we’re over-ETFed,” he says. “You can only slice and dice these indices so many ways.”

But Avi Nachmany, director of Strategic Insight, an asset management research company, expects innovation to continue for some time. The reason, he says, is that buyers of ETFs are not typical mutual fund investors. “It is relatively simple: they are not people who are buying and holding for a long time, they are not people who are saving for retirement.”

He believes ETFs are targeted at a very different market: “One third or more of ETF buyers are institutional investors including hedge funds. And the vast majority of the remaining two-thirds are individual owners through high-end advisors and brokers. ETFs are becoming accepted and convenient trading vehicles. ETF innovation is allowing them new ways to be successful.”

Mr Dolan of Sector SPDRs says that only when these new ETFs cease to be successful will innovation abate. “When you have a fund strategy that does well, 15 more follow it, and then it doesn’t work any more,” says Mr Dolan. “The ETF business is in still early in terms of its asset growth. But most of the big products are already out there, what we are seeing now is more marginal. A lot of what you are seeing now is an attempt to penetrate the retail market.”

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