ETFs are the new mutual funds
By James Williams – The inaugural etfexpress USA 2012 Awards demonstrate the growing range of new products and players in the burgeoning US marketplace, notes etfexpress Publisher Sunil Gopalan.
Opening the event, held recently at the Gansevoort Hotel in New York, he noted that this year’s winners demonstrated their ability to innovate and design sophisticated products allowing investors to track and tap into market trends using a broad range of underlying indices.
“In a market that is growing rapidly in terms of new products, it is becoming increasingly important for managers to distinguish their offerings and those that do so are clearly reaping the benefits”, says Gopalan.
A recent statistic perfectly illustrates the explosive growth that’s taken place in the ETF industry. Deborah Fuhr, founder of London-based ETF consultancy firm ETFGI LLP, notes that since the birth of the ETF industry in the US in 1993, total industry assets had already broken through the USD1trillion barrier by 2009 – in just 18 years.
Compare that to the growth of the US mutual fund market, which took 60 years to reach that level, and you get a clear idea of just how far the ETF industry has come in such a short space of time.
So popular have ETFs become, particularly among retail investors who now have access to products and markets that a generation ago simply didn’t exist, that they account for 35 per cent of average daily trading volume on the NYSE.
Through May, ETFs are up 6.1 per cent. Over the last decade, ETF/ETP compound annual growth rate stands at 26.5 per cent. In Q4 2011, the global market reached an all-time high of USD1.38trillion with 3,279 ETFs trading on 54 exchanges worldwide. Total AUM has crept up to around USD1.6trillion in 2012 on the back of USD85.3billion in net new assets through end-May (versus USD71.8billion end-May 2011).
This explosive growth could just be the start of things to come. McKinsey predicts that total global assets will reach USD4.7trillion by 2015, whilst the Strategic Insight Study suggests that US assets, alone, will double to USD2trillion in the next three years.
The US remains far and away the biggest market, accounting for 70.2 per cent of ETF assets, equivalent to some 1,098 listings and USD1.137trillion in AUM. By comparison, Europe has 18.4 per cent of the market. But Brian Brennan, Vice President BNY Mellon Asset Servicing, expects to see a great deal of growth in Europe as regulation evolves. The key pieces of regulation are the Retail Distribution Review (RDR) and UCITS IV. Although Brennan thinks it’s too early to tell whether the impact of these initiatives will lead to widespread adoption of ETFs, he says: “We anticipate ETF asset growth in Europe to be driven by such initiatives, as well as the change in investor behaviour that results from them. We anticipate ETFs will be put on a level playing field versus other investment vehicles when it comes to advisor flexibility in choosing suitable investments for clients as a result of these initiatives.”
From a performance perspective, and also in terms of net inflows this year, fixed income ETFs have stood out as the strongest and most popular asset class. This is perhaps little surprising given the volatility and risk on/risk off sentiment towards global equities amongst investors.
“Fixed income ETFs received the highest portion of net new inflows last year, and so far are dominating 2012 net new inflows,” confirms Brennan.
One of the best performers in 2012 is the Direxion Daily 20-year Plus Treasury Bull 3x Shares ETF (TMF), which has delivered 38.91 per cent over the last 13 weeks. Other ETPs that have done well in 2012 include: PowerShares DB 3x Long 25+ Year Treasury Bond ETN (LBND), up 35.6 per cent over the same period, and PIMCO 25+ Year Zero Coupon US Treasury Index Fund (ZROZ), which has returned 19.39 per cent.
Not to say that there haven’t been good performers in other asset classes. Within the specialty ETF space, the ProShares Ultra Nasdaq Biotechnology Fund (BIB) is up 57.89 per cent YTD, whilst in real estate, the iShares Dow Jones US Home Construction Index Fund (ITB) is up 43.04 per cent YTD.
“One of our most innovative, and successful launches of 2011 was the Global X SuperDividend ETF (SDIV) which scans the globe for the 100 highest yielding companies and equal weights them in a single ETF,” explains Bruno del Ama, CEO of New York-based Global X Funds.
Fuhr certainly believes that ETFs are living up to their name and delivering good value to investors. Their diversification, transparency, liquidity and low-cost index exposure have proved valuable. What’s more, says Fuhr, they are a “very democratic product”, pointing out that financial products exist where both retail and institutional investors have the same cost structure applied to them.
“I think ETFs are one of the greatest financial innovations in the past 20 years. Active funds are not consistently delivering alpha. Eighty-one per cent of large-cap active fund managers in the US did not beat the S&P 500 last year; it’s hard for investors to find good active funds.”
Volatility is not only prompting investors to look wider afield and allocate to ETPs, the fear of counterparty risk post-2008 is also driving demand.
“One of the key attractions of ETFs is that investors know they can get in and out of the markets during the same day. What we find is that many investors embrace ETFs during periods of market stress,” comments Fuhr.
ETFs, then, are helping investors become more tactical. Traditional asset classes are still the main preserve for investors due to their familiarity; alternative asset classes, like commodities, still form a limited portion of the overall asset allocation. According to Morningstar figures, only 1.5 per cent of assets are being allocated to commodities by investors.
That’s despite the fact that one of the main developments in recent times has been in ETF providers rolling out a myriad of commodity products. In 2004, the commodity ETP landscape was barren: just one product. Today, that landscape has evolved significantly, with 141 products available. AUM has grown to USD117billion, over which time net new inflows have averaged USD8billion p.a. Presumably, a chunk of these inflows has been originating from institutional investors.
“What we’ve seen looking across a 20-year period, is if you took a 60:40 portfolio in stocks and bonds and were aiming for an efficient portfolio, you should be holding 15 to 20 per cent in commodities,” explains Graham Day, Alternative Asset Product Strategist at Invesco PowerShares.
Given that 2011 was a tough year for commodities, and the fact that investors are so under-allocated, Day expects the growth trend to increase over time: “I don’t think we’ll see 15 to 20 per cent of total assets invested in commodity ETFs or mutual funds any time soon, but it’s reasonable to expect that over the next five years we’ll see 3 to 5 per cent allocation.
We believe people will continue to see the benefits of owning commodities in their portfolios going forward.”
Looking at performance this year, Day confirms that Invesco PowerShares’ flagship commodity fund, DBC, a broad-based commodity index fund developed by Deutsche Bank, is down 4.25 per cent YTD. This is slightly better than the iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP), which is down 4.62 per cent and the iShares S&P GSCI Commodity Indexed Trust (GSG:US), which is down 8.04 per cent.
Given the degree of political headline risk and choppiness of the markets over the last 18 months, one asset class that performed strongly in 2011 was volatility. VelocityShares, based in Darien Connecticut, focuses on three core markets: volatility, energy and metals. Its investor base is purely institutional, offering a range of ETN products that meet their specific needs.
Speaking with ETF Express, Will Lloyd, Managing Director, says that the firm’s biggest products are in the volatility space, which saw “significant growth in shares outstanding from December 2011 into January 2012”. This was growth was seen, in particular, in TVIX, VelocityShares’ 2x VIX short-term ETN. Currently the number of shares outstanding is 71.3million according to Bloomberg. Its AUM is USD516million.
“When volatility picked up people started taking views, either long or short, in volatility-related instruments,” adds Lloyd.
TVIX and XIV are VelocityShares’ longest running ETPs. Although TVIX is down 86 per cent YTD, XIV is by comparison up 83.8 per cent YTD. Lloyd says that being debt obligations they’ve performed as expected: “It’s more the growth in activity and trading volume that we look at.”
Lloyd notes that interest is starting to build in the firm’s long gas (UGAZ) and short gas (DGAZ) ETNs, which only launched this February, but it takes time for the markets to become aware of such new products as investors want to see liquidity develop before committing capital.
Continuing with energy, Day believes that with prices bottoming recently prices will almost certainly rise. “Energy futures are a great way of playing the market – they give you the best, most direct exposure to the commodity.”
People are seeing that a strategic allocation to broad-based commodity ETFs is potentially worthwhile, in Day’s opinion: “After all, even in a down year we still saw USD580million of inflows in the PowerShares DB Commodity Index Tracking fund (DBC).”
Opinion is split on the potential risks that synthetic, rather than physically replicated ETFs pose to investors. What seems clear is that ETF providers are building these products with institutional investors in mind: not retail investors who fail to understand counterparty risk. Lloyd comments: “If institutions want to express specific views, these are tools that allow them to do that.”
Brennan says that a great majority of ETFs are synthetic rather than physically backed, but that BNY Mellon supports both types. “We do see that several issuers in Europe are moving away from a synthetic-based model towards a replicated model. At BNY Mellon we do a thorough analysis of all products completed by our risk department with recommendations for additional controls. We limit synthetic and/or derivative products serviced to only those registered under stringent guidelines (UCITS, SEC).”
The BOE still views synthetic ETFs as risky. In their latest stability report they refer to them as being opaque, putting them in a high-risk bucket. In Fuhr’s opinion, what’s more of a concern is making sure people understand different products. She thinks classification needs to be better: “If it’s a true ETF, call it that. Don’t try and wrap everything in the same name. ETNs, for example, aren’t regulated as funds. You can have models within a note that will generate different costs depending on performance and other things. You have 100 per cent counterparty exposure.
“However, I do see synthetic products offering tools that are useful as ETFs. They are useful because they allow investors access to asset classes like China A shares that would otherwise be difficult to access.”
Clearly RDR in Europe should see greater uptake in ETFs, which will benefit US providers as they attempt to build assets. This will also be driven by the fact that active managers are underperforming their benchmarks and causing investors to look at alternative, lower-cost options.
Day says that the switch from mutual funds to ETFs will continue, particularly with respect to North America’s younger generation. “They’re not investing in mutual funds anymore. When they’re accessing the market they’re trading ETFs so I think as the younger generation ages and invests more, ETFs will become even more highly used than they are now. Today, they want to access a specific space and trade it with an ETF.”
From a product perspective, Lloyd says that one important area of development is tail risk. “Most of the generic conversations we’re having with investors shows that they’re a little uneasy with things right now. They’d like to find an efficient way to get tail risk exposure. We’re working on ideas to address this need.”
Fuhr thinks that going forward, as people look for pension solutions, the focus will be on finding new applications for existing ETFs and that funds of ETFs will become more popular in the UK and Europe as advisers go from selling products to advising on them.
“I think we’ll see the development of funds that use ETFs as the building blocks for risk/return profiles. The next trend will be more in the uses of ETFs rather than necessarily developing new products. However, it takes education for people to understand that they’re out there."
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