If there was ever a time of fervor in the exchange-traded fund market, this is probably it. This summer represented a period of record trading volumes for ETFs, taking total assets under management to some $862 billion in June.
Such a high water mark represented a 7% jump from the previous record set in April 2008. (See story here.)
While the number of individual company IPOs is fairly benign right now – that’s to say, lots of recent filings but only about 10 listings this year – providers have been rushing out new products faster than you can say ETP.
Some of these, such as HSBC’s FTSE 100 Index Fund (London: HUKX) represent an institution’s debut into the ETF arena. Others, such as Pimco’s 1-5 Year U.S. TIPS Index Fund (NYSEArca: STPZ) are first-of-kind ETFs, replicating previously untracked products or categories (in this case, inflation-protection).
All these new product launches, combined with the number of firms who are suddenly entering the ETF arena for the first time, have caused some analysts to speculate recently that the industry will expand to some $3 trillion in the next three years or so. That would take it from around 80% of the size of the hedge fund industry right now, to around double the size.
Whatever the actual growth numbers end up being, it’s clear there’s some serious expansion underfoot. With that in mind, it’s worth thinking seriously about the potential effects on the industry as a whole. As I see it, there are three primary consequences of such historically unprecedented expansion.
The first consequence is that many funds will get launched and subsequently attract little trading interest – at least for a bit. This has been one of the main subjects of debate around the ETP water cooler recently, and for good reason. For the whole point of having an exchange-traded product is that it attracts buyers and sellers, and hence forms a liquid marketplace where you can find plenty of others willing to take the other side of the trade.
This point is especially prescient when you consider the dazzling array of ETFs currently available. As new providers enter the market, they will be forced to come up with ever more inventive niche-industry products that have only a small cadre of followers familiar with the sector which the fund tracks.
The second consequence of dramatic ETF product-expansion is almost contrary to the first. Because of the diversity of the sectors being tracked, there will be funds that for no other reason than they are exotic or exciting end up attracting a large number of investors for short spaces of time.
This will have the net effect of creating some substantial volatility in the marketplace, sending some ETFs soaring way past their net asset values and eventually slumping back when arbitrageurs have swooped in for the kill.
The last consequence is, in my view, the most potentially exciting and dangerous of all. Because product expansion in the trading arena tends to always end up veering towards those with shorter-term, more volatile returns, you will see many more ETFs launched which have the potential to yield double percentage-point returns in a day or two.
In a white-hot ETP market, with multiple sector-specific funds, it’s not so hard to imagine an ETF provider developing some kind of actively managed fund which in effect aims purely to yield maximum volatility while providing some diversification.
For example, an ETF which tracks companies that are buyout targets (periodically switching focuses) would be able to differentiate itself pretty well in an overcrowded pit.
Needless to say, these kinds of products could end up creating some pretty serious distortions of value as they attract highly-leveraged speculators with ultra-short-term holding time horizons.
To some extent, this process is already beginning to take place. Leveraged products such as the recently-launched Direxion Daily Real Estate Bull 3x (NYSEArca: DRN), an ETF which aims to replicate the MSCI U.S. REIT Index with three times the daily performance, are purely designed to be traded on a daily basis: the provider actually warns investors not to hold it for the long-term.
Bear in mind that this is all entirely consistent with how financial product development has historically panned out. At first, a product is developed in order to provide a safe, or hedged way to access a market. After that, it’s just a matter of time until others figure out ways to ramp up the potential winnings, and in the process, the risk.