A number of key milestones are expected for the ETF industry this year, with global assets under management nearing $1trn and the 1000th product likely to launch.
This year also marks the 10th anniversary of the first listing in Europe and the market has grown to $220bn in its first 10 years.
ETFs have been relatively slow to achieve mainstream status among UK investors but are finally gaining momentum, with a further push expected from RDR changes.
The most obvious change in ETFs over the last 10 years has been the evolution of the investments on offer. The earliest products focused on major equity indices but they have become much more diverse and specialised since then.
ETF manager Lyxor Asset Management, for example, has seen a typical growth in the products it offers. The first offerings listed on the Euronext index in 2001, tracked broad indices like the Cac 40 and Eurostoxx 50.
Claus Hein, who heads Lyxor ETFs for the UK, Nordics and Latin America, says: “Lyxor was among the first providers in this area and earliest products were largely focused on developed equity benchmarks and used by institutional clients. In the years since, several more players have entered the market and ranges have expanded significantly, tracking regional and sector equity indices as well as bonds and commodities.”
Generally speaking, there are now ETFs for the vast majority of indices – providing liquidity is sufficient – covering all asset classes in significant depth.
In commodities, for example, products offer specific exposure to areas as diverse as corn, cotton, coffee and lean hogs, should investors want such bets.
Over recent years, the European market has proved a fertile area for ETF firsts, with the Ucits regime allowing products linked to money markets, credit indices, interest rates and hedge funds.
’If investors want to rotate sectors in their portfolio, ETFs are the cheapest and easiest route to take a long tech and short financials’ position, for example’
In addition to the increased specialisation of funds on offer, the main development in the market has been the noticeable divide in the structure of ETFs, with certain groups opting for physical index replication and others using derivatives to mirror performance.
The former method, also known as cash or full replication, involves purchasing all the underlying stocks in an index – or at least a representative basket.
HSBC Global Asset Management head of market proposition David Chellew says full replication has the advantages of transparency in underlying positions and no counterparty risk.
But he says this can lead to other issues. “With larger indices, however, groups using physical replication often use sampling techniques as holding the 1,700 stocks in the MSCI World would be difficult and expensive. These ETFs only purchase a sub-set of index components, which reduces admin and transaction costs but leads to higher tracking error away.”
Several companies use synthetic replication based on swaps, with a counterparty agreeing to match index performance.
This opened the ETF world to other asset classes – including commodities and money markets – as it offers index returns without owning the underlying securities.
These products should mirror their benchmark precisely but using derivatives introduces counterparty risk as an issue and this blew up amid the market carnage of 2008, particularly as Lehmans and AIG were active in the counterparty sector.
Since then, a number of groups using swap-based replication have fully collateralised their range to eliminate this risk.
Deutsche Bank head of European equity options strategy Pamela Finelli says buying a synthetically-replicated ETF implies counterparty risk but only up to the size of the swap.
She says: “Under Ucits rules, the maximum exposure to a swap counterparty is 10 per cent of net asset value, hence synthetically-replicated ETFs are at least 90 per cent collateralised. Most major providers also have a policy to reset swaps well before the 10 per cent threshold is reached and as always, investors should refer to a fund’s own policy.”
At one stage in 2008, more than 100 exchange traded commodities from ETF Securities had to be suspended from trading after market makers lost confidence in their backer AIG.
They later resumed trading after the Fed announced ongoing support for the insurer. At the time, many ETF providers moved to distinguish their product from ETCs, a type of exchange traded note.
These are debt instruments rather than funds, with some backed by physical assets and others by an issuer or guarantor like AIG.
Several groups have used them for commodity offerings as it is not possible to hold a single asset within a Ucits III ETF.
To reassure investors, ETF Securities collateralised its ETCs that track DJ-AIG commodity indices, removing counterparty risk.
More recent innovations in the ETF world have focused on short and leveraged products, allowing investors to play short-term market trends.
Tony Yousefian, CIO at wealth manager OPM, says if he feels a market has risen too quickly and is set for a pullback, for example, he can buy an appropriate reverse ETF to reduce risk.
He says: “These tactics are only possible owing to the cost effectiveness, transparency and efficiency of ETFs to replicate the underlying index. When making short-term moves, we avoid buying and selling collectives as we have relationships with groups and do not want to be labelled a trader.”
Among providers, Hein said these products can be useful for short-term investors but it is vital to understand how they work. “Most have a daily reset and if someone is investing for the long term, the compounding effect of that could mean returns are not what people expected.”
Elsewhere, other recent ETFs follow more ’active’ indices, which advocates claim can enhance returns. This strategy is based on the view that market cap is an inefficient way of indexing, as share prices are largely sentiment-led and not driven by fundamentals.
Tim Mitchell, head of listed fund sales at Invesco Perpetual – which owns ETF provider Invesco PowerShares – says: “Traditional benchmarks ride all the way up and down with bubbles and typically leave investors overweight in overvalued stocks and underweight in undervalued. This is easy to fix by breaking the link to share price.”
As an alternative, PowerShares has launched several products that track the FTSE RAFI series of indices. These are based on four fundamental stock factors – cashflow, book value, sales and dividends.
Mitchell says this generates improved beta rather than alpha and should not be seen as active management as no investment decisions are being made.
Compared with a basic UK ETF, going back to 1984, the fundamental-based fund would have generated additional performance of 270 basis points a year, which many active managers would struggle to achieve.
Perhaps the most significant change for ETFs has been in the general shifting of attitude in the active versus passive investment debate. These styles are no longer seen as mutually exclusive and, in this context, providers now sell tracker products as building blocks.
Most advisers now use them as part of a core-satellite investment approach alongside active products, either for cheap beta or more tactical plays.
Of the other major US ETF companies, State Street Global Advisors believes the active/passive debate looks increasingly unsophisticated.
The group’s senior managing director Jim Ross says that as asset allocation grows in importance, passive instruments like ETFs can be used to implement active strategies.
Ross says: “If investors want to rotate sectors in their portfolio, ETFs are the cheapest and easiest route to take a long tech and short financials’ position, for example. In those circumstances, managers have to ask themselves whether they want to be buying Apple, IBM and so on or simply pick up a tech ETF.”