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Last year, the three most actively traded securities on the big US stock exchanges were not companies – they were the exchange traded funds matching the S&P 500, the Nasdaq 100 and the Russell 2000 indices.
State Street’s S&P 500 ETF, known as the Spider, sees turn-over of more than $10bn a day, making it more liquid than any stock in the world.
Meanwhile, the number of ETFs on offer has ballooned. In the first 11 months of last year, according to Deborah Fuhr of Morgan Stanley, the number of ETFs listed in the US rose from 203 to 347. Another 343 were in development as of last month. ETFs now manage more than $410bn in the US alone while they are also establishing themselves, more slowly, in the UK, continental Europe and various markets in the Asia-Pacific region.
The sector has come a long way since the first ETFs were introduced little more than a decade ago but with its new size and prominence have come important questions. What place do ETFs have in the investment industry? Will they displace mutual funds, currently the most popular vehicle for retail investment management, or will they mature into a distinct asset class? How far can the ETF concept develop and who will take the lead?
Initially, ETFs were designed to track the main stock indices and grew in popularity just as the concept of indexation was taking hold among mutual fund investors in the mid-1990s. The biggest providers by far were well-established as big providers of passive investing for mutual funds and pension funds – Barclays Global Investors, State Street and Vanguard.
BGI currently dominates the market through its iShares products and has more than half of the US market.
State Street, which introduced the first ETF, has responded this month by rebranding all its ETFs as SPDRS (pronounced “Spiders” and named after its pioneering ETF that tracks the S&P), and launching an aggressive advertising campaign. Vanguard, which has the largest passively managed mutual funds and is the largest provider selling funds directly to the public, still appears to emphasise mutual funds much more than ETFs in its marketing.
The growth of the industry in the past year has brought proliferation. The bulk of ETF assets are still held in big passive funds run by these three groups that do much the same job done by index-tracking mutual funds. But these funds have been sliced and diced to allow the expression of almost any asset allocation model – by market size, by geography and by industrial sector.
As different providers use subtly different indices, there are already complaints from investment advisers that the funds differ more than appears and that this could confuse investors.
More interesting, the exchange-traded concept was last year extended beyond equities and fixed-income to allow trading in asset classes that were previously too illiquid or too expensive for individual investors to gain access to.
Strictly not “funds,” but more “exchange-traded notes,” ETFs now exist to match futures in a range of foreign exchange rates, commodities and commodity indices. Different structures are being used, several of which have been patented. Generally, these securities come from companies new to the market that are not already established in mutual funds.
In many of these structures, an investor’s underlying investment is in futures rather than in a basket of stocks. For example ProShares, one recent entrant to the market, offers “ultra” funds that promise to double the return of their underlying index each day. They also come in “short” varieties, so that you get a positive return of double whatever that index lost.
The ETF space also now includes what PowerShares, a US player that was bought by Amvescap of the UK last year, calls “intelligent” ETFs. These are still rigidly quantitative investments but they follow indices that have in many cases only been drawn up so that they can be used for an ETF. With some ETFs planning to turn over their entire portfolio each year, this is not “passive” investing as usually understood. Rather, it is active investing using a quantitative screen.
This space has also quickly become crowded. The concept of “fundamental” indexing has grabbed the most attention. This involves drawing up an index using measures other than market value, which, fundamental indexing’s proponents argue, ensures overweighting stocks that are already overvalued by the market.
The next question is whether someone will launch a true active ETF. Bruce Bond, the chief executive of PowerShares, suggests that “active” ETFs as such are already here. Many ETFs are active but quantitative. Thus, all that is missing is an ETF that allows for qualitative decisions by a portfolio manager. The problem is that the Securities and Exchange Commission requires that ETF portfolios are made public on a daily basis – a condition that opens large active managers to the risk of “front running”.
This is difficult to do under the regulations that maintain the transparency of ETF portfolios. Various players are experimenting with a structure that would deal with this problem. Once someone has a method that works, it seems fair to expect many to follow. Lee Kranefuss, head of BGI’s iShares, currently the market leader, says his group would “love” to find a way to offer BGI’s various quantitative investment strategies as ETFs.
Truly active ETFs would also bring the new securities into much more direct competition with mutual funds. Up to this point, there is an interesting debate over whether their growth has been at the expense of established funds. Key advantages of ETFs, such as the ability to trade through the day and to sell short, have been of interest largely to day traders and hedge funds, who would not have used mutual funds.
Jim Ross, head of State Street’s ETF business, points to the exceptionally heavy trading in the Spider – activity that would never be seen in active mutual funds – and questions whether ETFs have encroached at all on mutual funds.
Other advantages, such as low costs and apparent superior tax-efficiency, however, might well help them to take market share away from mutual funds.
Is the industry overcrowded? Mr Bond denies it. “Mutual funds reached $400bn in assets [roughly the amount currently held by ETFs] in 1984,” he says. “There were 1,200 mutual funds in 1984, and there are only about 400 ETFs now. So there is less proliferation in ETFs than there was in the early days of the mutual fund industry. And it’s understandable you’re going to see more offerings and more competitors.”
Drawing further parallels with the growth of the mutual fund industry, which expanded to $2,000bn in assets over the ensuing decade, he points out that there were 400 new mutual fund launches each year over that period.
“If history repeats itself,” he says, “I think you’ll see the ETF industry has actually been very conservative.”
Some analysts are dubious. Tom Roseen, who covers the sector for Lipper, points out that intrinsic advantages of ETFs may erode as the sector becomes more complex.
Apart from their simplicity – an aspect which, tellingly, State Street is trying to emphasise in its new campaign – the new, more heavily traded strategies could lose tax-efficiency. Further, the costs are increasing, narrowing another key advantage compared with mutual funds.
With truly active funds, the advantage of being able to trade at any point in the day is also reduced, he points out. Betting that a sector will drop after some information comes out at 2pm is one thing; betting that a fund manager will suddenly make a bad decision at 2pm is quite another.
But their more aggressive proponents argue that ETFs are “disruptive technology” that can displace the position of mutual funds in the US. Don Putnam, of Grail Partners, long one of the most influential investment bankers in the fund management industry, believes the mutual fund industry’s powerhouses will have switched their funds to ETFs within a matter of years.
He summarises the advantages swiftly – they are less expensive, they have the efficiency that comes from trading on an exchange and they are easier to use when constructing an asset allocation model. More importantly, he says, they take away a lot of the problems of the mutual fund business, such as difficult boards, intrusive regulation and costly administration.
“The business of running ETFs is a better business than running mutual funds, even at lower prices. Some time in the next two or three years, we will see fund companies stop resisting and start adapting. Some time soon, a big mutual fund house – someone with more than $100bn under management – is going to say this is a good idea to be embraced and, when they do that, it will send shockwaves through the industry.”
ETFs have multiple uses: So if you want to . . .
■Bet that the oil price will go down: You can either buy “Oil Down” tradeable shares from Claymore MacroShares, which undertake to go up by the same percentage that the West Texas Intermediate crude contract goes down each day; or borrow and then sell short the iPath Goldman Sachs Crude Oil traded security.
■Buy stocks in companies where the insiders are buying: The Claymore/Sabrient Insider ETF will invest in 100 securities at any one time where the insiders have been buying recently.
■Invest with Social Responsibility: Morgan Stanley lists four socially responsible ETFs to date. PowerShares has two “green” ETFs that trace clean-up and clean energy stocks, while iShares offers the opportunity to track the Domini 400 Social Index, which uses several social screens.
■Bet that the dollar will recover against the Euro: Borrow and sell short the Rydex Euro Currency Trust. PowerShares has filed a prospectus for a “DB US Dollar Index Bearish Fund”, which may yet save you from the bother of selling short.
■Invest for income: There are now 13 different ETFs using different indices designed to aim for stocks that pay a high dividend yield. Providers include SPDR, First Trust, iShares, PowerShares, Vanguard, and WisdomTree.
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