With new products emerging and a streamlined global regulatory regime on the horizon, the scope and popularity of exchange traded funds is growing.
At the end of last year, there were 1,171 primary ETF listings on 41 exchanges worldwide, a 64% in-crease in the number of offerings, compared with a year earlier, ac-cording to Morgan Stanley of New York. Issuers were expected to launch an additional 547 ETFs this year, including 399 in the United States and 90 in Europe.
ETF assets under management at the end of last year totaled $797 billion, a 41% increase over the end of 2006. Meanwhile, the worldwide 20-day average daily trading volume climbed 143% to $60 billion, from $25 billion.
The proliferation of ETFs isn't likely to slow down anytime soon.
In March, the Securities and Exchange Commission voted unanimously to propose a rule change that would allow ETFs to operate without having to obtain individual exemptive orders. If passed, the rule change would significantly streamline the approval process for ETFs closely resembling other funds already on the market.
Although they traditionally track such equity indexes as the Standard & Poor's 500 stock index or the Nasdaq Composite Index, ETFs are expanding into other asset classes, including commodities. As a result, it is just as easy for an asset manager to take a position in gold these days as it is to take a position in the S&P 500.
FIXED INCOME
A recent development in the U.S. market has been the proliferation of fixed-income ETFs. Such funds took years to establish, partly because of the lengthy approval process and because of complexities involved in creating fixed-income funds.
Fixed-income securities reach their maturity dates and have to be replaced with other bonds — a process that is very challenging to manage.
Nevertheless, these products bring the benefits of transparency, liquidity and low fees to investors.
Then there is the recent emergence of actively managed ETFs.
Indeed, such funds will likely become the next important component of the listed-funds market.
Like actively managed mutual funds, actively managed ETFs attempt to outperform a benchmark, not merely replicate one. The stocks in active ETFs can be selected by a manager or picked by a computer-driven model.
Actively managed ETFs have been in the works for some time. Their issuance was delayed, however, by technical difficulties related to reporting the funds' net asset value.
The SEC insists that an ETF provider disclose on its website the identity and quantity of positions held by the ETF before trading on each business day, which helps form the basis of periodic calculations of NAVs for the next business day.
The first actively managed ETF hit the market at the end of March in the form of the Bear Stearns Current Yield Fund, from The Bear Stearns & Co. Inc. of New York.
This was followed in April by the launch of another actively managed fixed-income ETF, the PowerShares Active Low Duration Fund, from Invesco PowerShares Capital Management LLC of Wheaton, Ill., as well as three actively managed equity ETFs: PowerShares Active Alpha Multi-Cap Fund, PowerShares Active AlphaQ Fund and PowerShares Active Mega Cap Fund.
Barclays Global Fund Advisors of San Francisco, State Street Global Advisors of Boston,
The Vanguard Group Inc. of Malvern, Pa., and WisdomTree Investments Inc. of New York, appear ready to enter the market.
Exchange traded notes are another innovation. They are simple, linear products linked to the performance of an index. Unlike an ETF, an ETN isn't backed by a specific pool of assets but by an agreement with the note's issuer — typically an investment bank — to give the buyer the returns of an index or benchmark.
POPULARITY OF ETNS
The potential of ETNs is an open question. Many ETNs are linked to commodities, currency or strategic plays — such as covered-call-writing strategies. This product could pose a challenge to the new generation of actively managed ETFs, but the competition among alpha generators will be a healthy one.
A manager who can select investments whose performance exceeds a pre-selected benchmark without additional risk is creating alpha.
Compared with traditional mutual funds, ETFs have certain tax advantages — among them a significantly lower level of capital gains distributions. Because they use securities to meet their redemption requests, ETFs don't recognize taxable gains on securities distributed to shareholders.
As a result, most of the funds distribute only net investment income as dividends and generate few capital gains.
Many money managers are using ETFs as part of their asset allocation process. For example, the products have proved effective in core satellite strategies, in which a manager combines active and passive investing. Broad-based ETFs serve as diversified, stable core holdings, while the satellite components invest in sectors, regions, stocks, styles or other assets that managers can overweight.
They can also use the offerings to invest idle cash through a process known as cash equitization. Because ETFs are traded easily and inexpensively, they are a vehicle for making temporary allocations while a longer-term strategy is considered.
ETFs can also assist portfolio managers in navigating transitions. A pension fund, for example, might use ETFs to maintain equity exposure while searching for a new money manager.
The proliferation of new products and new entrants into the market is creating other challenges as well.
Some ETF managers are concerned that the number of new products and ETF offshoots could confuse investors.
Not surprisingly, established and emerging sponsors are fighting to differentiate themselves in this increasingly crowded marketplace. Because some firms received venture capital, there could be more pressure to perform — pressure that is likely to be felt sooner rather than later.
The competition is far different from the days when ETF managers could differentiate themselves by being the first to Wall Street with a novel strategy to build assets in a rapid fashion.
With increased competition, ETF managers will be judged more often on returns, liquidity and expense ratios — all hallmarks of a buyers' market.
Matt Forstenhausler is a partner in the financial services office's registered-funds practice at Ernst & Young in New York. Joseph F. Grainger is a partner in the company's Americas Asset Management Center in New York.
