The Next Five Years In ETFs

By
Matt Hougan
September 10, 2009
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The rush to enter the ETF field remains at near-peak levels. But the proliferation of new listings could change the market's landscape.

Daniel Harrison’s blog on the current fervor in the exchange-traded fund marketplace has me thinking about the future of this industry.

If you didn’t read the piece, it’s available here.

Daniel notes a rush in filings. Indeed, we're near peak levels on filings.  According to ETF Watch, there are currently 518 ETFs in registration at the Securities and Exchange Commission. That’s on par with last year’s record levels (526) and way above levels seen in September 2007 (397, according to our records).

There can be no mistake that the rush of major firms filing to enter the ETF market is unprecedented, at least in recent memory. From Charles Schwab to John Hancock, Jefferies, Manulife Financial, Old Mutual and Pax World Funds, the mutual fund industry has definitely woken up to the threat posed by ETFs, and they’re responding.  The mantra appears to be, “If you can’t beat ‘em, join ‘em.”

Let's add another layer of perspective, however. At least in the U.S., we’re on pace for a down year in ETF listings. By my count, we saw 67 ETFs come to market in the U.S. in the first eight months of this year, for an annualized rate of about 100 ETF launches.  That would be down more than 50%  from the 220 ETFs that launched in 2008, and the record 292 that launched in 2007.  It would also fall short of 2006’s 160.

What It All Means

Daniel outlines three major consequences that all this activity will have on the ETF space, and not all of them are good.

First, he worries about the proliferation of narrow, niche ETFs that trade with wide spreads, and that slice and dice the market. It’s a concern I share.  Already, nearly 50% of ETFs trade with average spreads of 0.5% or more, a group I call the “zombie underclass” of the ETF market.

As I scan through the list of new products in registration, I see quite a few that seem destined for this list as well. These funds can hurt investors, as the fees for entering and exiting the funds are enormous.

At the same time, the new and important asset classes that the ETF industry is opening up constantly amaze me.

The world’s first “all-world” ETF didn’t launch until April 2008, but the iShares MSCI ACWI Fund (NYSE Arca: ACWI) now has over $550 million in assets, and someday will have billions.  Just a few weeks ago, Pimco launched a new Treasury Inflation Protected Securities ETF that I think could be a category killer. (See related story here.)

People have been saying there are “too many” ETFs for a decade. So, while many new ETFs are overly narrow, I guarantee there are some future mega-funds amongst the filings as well.

I also think that some of the “me-too” ETFs in registration will slowly, but steadily, steal market share from competitors.  There’s a belief in the ETF industry that the first mover always wins, but recently, investors have been more discriminating.

Investors More Selective

For example, Vanguard’s Emerging Markets ETF (NYSEArca: VWO) is a better fund than the overpriced iShares MSCI Emerging Markets ETF (NYSEArca: EEM), and over the past few years, it has been stealing market share.

Similarly, the ETFS Silver Fund (NYSEArca: SIVR) gained nearly $100 million in assets in August, while the iShares Silver Fund (NYSEArca: SLV) lost $73 million.  SIVR provides the same exposure with a much lower fee.

Examples like these give me hope that the addition of “me-too” funds can actually be a good thing for investors, particularly if they push the envelop on costs.

Daniel’s second worry is that the proliferation of ETFs into “exotic” asset classes will lead to ETFs that trade at high premiums and discounts to net asset value. We’ve certainly seen this in the fixed-income market, where premiums and discounts are endemic, as well as in special situations such as the closed commodity funds.

The thing to understand here is that the primary driver of premiums and discounts is the liquidity of the underlying securities. So, as ETFs move into less liquid markets, Daniel is probably right that premiums and discounts will increase. I think it’s an open question whether or not ETFs are a good mechanism for accessing corporate debt, and the same question will apply in other illiquid categories.

For ETFs tied to liquid markets, such as most segments of the equity space, there’s no reason to be alarmed.

 


Daniel’s third point, which I think is the most interesting, is that some so-called experts expect to see more product development aimed at the trader community.  They envision ultra-volatile funds that jump and dive 10% in a given day.

Focused On Traders

I’m not sure such volatility is necessary, but I do agree that more ETFs will be launched focused on the trader community.  One flaw in a lot of what passes for ETF analysis these days is that it views funds through the lens of a buy-and-hold investor, measuring their validity using mutual fund-type metrics.

That makes sense for many ETFs and ETF users, but not everyone: There are some ETFs that are designed and exist primarily for the trading community, and there’s nothing wrong with that.

The SPDRs S&P 500 ETF (NYSEArca: SPY) consistently trails the iShares S&P 500 ETF (NYSEArca: IVV) on a total return basis because it is structured as a grantor trust, and does not automatically reinvest dividends.

But SPY is the most liquid security in the world, and is better for trading.  I think we’ll see increased bifurcation in the ETF market over the coming years, with more trading tools (think leveraged funds) and more investor tools (think ultra-low-cost buy-and-hold securities).

The biggest impact of all this recent activity is that many experts expect global ETF assets to grow towards $2 trillion-$3 trillion over the next few years.

I think that’s either accurate or conservative.  A number of big factors are lining up in favor of a substantial jump in ETF assets, including not just the move of big companies into the space, but also the growing understanding of ETFs among investors and recent breakthroughs in applying ETFs to the 401(k) market.

This still feels like an industry in its infancy, and despite a few challenges, it feels like significant growth is ahead.


Matt Hougan is director of analytics for IndexUniverse.com. He welcomes comments and suggestions for columns at: mhougan@indexuniverse.com.

 

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