ETFs - Past, Present, Future

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  • 1. ETFs: Past, Present, and Future Bradley Kay Associate Director, European ETF Research Ben Johnson ETF Strategist, European ETF Research March 25 th , 2010
  • 2. Overview
    • A Very Brief History
    • The ETF Marketplace Today
    • What Is An ETF?
    • What Advantages Do ETFs Offer?
    • Trends For The Future
  • 3. Whence We Came: ETF Market Evolution
  • 4. A Very Brief History
    • 1990 – The SEC issued the Investment Company Act Release No. 17809. This would ultimately facilitate the creation of mutual funds that were able to create and redeem shares intraday.
    • 1993 – SPDRs S&P 500 begins trading on the AMEX in January.
    • 1999 – The Tracker Fund of Hong Kong (TraHK) was launched in November, becoming the first ETF in Asia.
    • 2000 – In April, the European Exchange Traded Fund Company launched a pair of listed diversified return securities (LDRS) on the Deutsche Borse. The funds, which tracked the EURO STOXX 50 and STOXX 50 indices were co-managed by Merrill Lynch. Later in the same month, iShares launched the first ETF in the UK, the iFTSE 100.
    • 2003 – In February the first ETF on a fixed-income index in Europe was launched. The ETF eb.rexx Government Germany was issued by Indexchange and tracked the Eurex Bonds Government Germany index (eb.rexx).
    • 2003 – ETF Securities launches the world’s first exchange-traded commodity Gold Bullion Securities in Australia and London.
  • 5. European ETF Asset Growth by Broad Asset Category Source: Blackrock, Bloomberg
  • 6. Where We Are Now
  • 7. Proliferation of Asset Classes Category/Asset Class # of ETFs Total Net Assets As a % of Total Industry Assets Europe Equity 424 60,526,666,986 42.47 International Equity 243 32,723,777,179 22.96 Fixed Income 153 30,582,153,845 21.46 Traditional Asset Classes 820 £123,832,598,010 84.68 Commodity 291 16,982,675,211 11.92 Other 18 1,476,473,085 1.04 Currency 22 208,379,461 0.15 European ETF Industry Total 1151 £142,500,125,766 100.00 Morningstar Data as of Feb. 2010
  • 8. Proliferation of Asset Classes
    • In the beginning, ETFs only offered broad index and equity sector exposure
    • Now, ETFs offer access to nearly every asset category imaginable
      • Fixed Income
      • Fundamental Indexes
      • Commodities
      • Currencies
      • Leveraged Equity
      • Hedge Fund Strategies
      • Niche Sector Slicing
  • 9. What Is An ETF?
    • An umbrella term, covering a broad array of legal structures with a proliferation of abbreviations
      • ETFs
      • ETCs
    • Defining attributes
      • Tracks a specific index or a strictly-defined portfolio of securities
        • Almost exclusively passive investments
      • Traded on a stock exchange
        • A retail investment vehicle by nature
      • Short-term arbitrage opportunity via daily or weekly share creations/redemptions
      • ETNs
      • ETPs
  • 10. What Is An ETF?
    • Typically UCITS III compliant
      • Diversified portfolios of securities: stocks, bonds, derivatives
    • Physical-replication ETFs
      • Match their index by holding the actual securities in a unique trust
      • Full or Sampled replication
    • Synthetic-replication (or swap-based) ETFs
      • Obtain their index exposure through OTC swap contracts
      • Hold securities in their own trust and/or have collateral pledged to mitigate counterparty risk
  • 11. What Is An ETC?
    • Formerly “Exchange-Traded Commodity”, now also currency funds
    • Typically does not meet diversification standards for UCITS III
      • Single commodity funds
      • Single currency funds
    • Debt instruments issued by Special Purpose Vehicles (SPVs)
      • Degree of counterparty risk varies widely
    • European Union Prospectus Directive allows broad distribution
  • 12. What Is An ETC?
    • Physically-backed
      • Only precious metals
      • Virtually zero counterparty risk
    • Synthetic-replication
      • SPV sometimes keeps the ETC’s capital, but usually given to total return swap (TRS) counterparty
      • Collateral may be allocated through a third-party custodian or simply pledged by the TRS counterparty
      • Acceptable securities for collateral can vary widely from provider to provider
      • Read Those Prospectuses!
  • 13. What Is An ETN?
    • Exchange-Traded Note
    • Debt instrument issued by a backing bank
      • Senior, unsecured debt of that bank
      • Substantial counterparty risk!
    • Not a very popular vehicle in Europe, with only two issuers
      • Lyxor pledges collateral for their ETNs
      • Barclays Capital issues uncollateralized ETNs
    • Much more popular in the U.S., where they have substantial tax advantages for futures-dependent indices such as commodities
  • 14. Innovation, You Say?
  • 15. What’s So Great About ETFs?
    • Incredibly low costs
    • Intra-day liquidity and real-time trading
    • Access to new asset classes and strategies
    ETFs bring the institutional to the individual
  • 16. Low Costs
    • Passive investments
      • No expensive analysts
      • Typically low turnover
    • Numerous back-office and mid-office efficiencies for providers
      • Only need to issue and redeem shares with a limited number of market makers
      • Shifts portfolio trading costs to ultra-efficient market makers or swap counterparties
    • Custodial costs have economies of scale due to cross-listings and broad distribution pulling in assets from across Europe
  • 17. Intra-Day Liquidity and Real-Time Trading
    • Real-time execution means that you know the price you are paying
    • Can provide more liquid exposure to illiquid asset classes
      • When corporate bond markets froze in 2008/2009, credit bond ETFs kept trading
    • Market makers arbitrage away premiums and discounts, keeping prices close to fair value
    • Warning: This shifts the onus of ensuring fair execution onto the final buyer rather than the provider
      • Liquidity differs from fund to fund
  • 18. Access to New Asset Classes & Strategies
    • Funds for in-house use with sophisticated clients are now easily offered to retail investors as well
      • Physical precious metals
      • Asset allocation strategies
      • “ Alternative betas”
    • ETFs serve as a wrapper for futures contracts that would otherwise have too high of a minimum size for retail investors
  • 19. Where Do We Go From Here
  • 20. Expansion of the Retail Market
    • Everyone in the industry is waiting for the retail market to appear, but it will be harder than expected
    • Four major preconditions to a robust retail ETF market in Europe
      • Increased retail investor demand
      • Greater trading volume / visible liquidity
      • Greater transparency
      • Simple cross-border transactions within EU
  • 21. Expansion of the Retail Market: Investor Demand
    • Need to make the case to individual investors for low cost and passive investment
      • Who will be the UK’s Jack Bogle?
    • A critical mass of advisers and other financial professionals looking for low cost vehicles
      • Organic movement toward fee-based financial advice took decades in the US
      • Regulatory pushes in Europe may accelerate the process
      • (UK’s Retail Distribution Review)
  • 22. Expansion of the Retail Market: Greater Trading Volume
    • OTC trading volume does not do much for retail investors
    • Need to recruit a new sort of institutional investor, as heavy exchange traders and retail investors have a natural symbiosis in ETFs
      • Make shorting ETFs easier
      • Movement toward ETFs as cheaper, easier, and more flexible than other forms of beta exposure (futures, swaps, etc.)
    • Moving trade volume onto the exchanges is a self-perpetuating process once it starts, as greater liquidity makes larger on-exchange trades easier, which in turn generates more liquidity
  • 23. Expansion of the Retail Market: Greater Transparency
    • Apply MiFID to exchange-traded funds
      • Reveal all liquidity to all market participants
      • Help retail investors feel comfortable that the playing field is level
    • Retail investors want to know what they are holding
      • Full portfolios published frequently and with little delay
    • Synthetic replication ETF providers will have to win not just on cost and on tracking, but also have to match the openness
      • Make collateral rules easier to find
      • Disclose collateral portfolios as well as index portfolios
      • This information is already available to institutional investors
  • 24. Expansion of the Retail Market: Cross-Border Transactions
    • Liquidity makes ETFs a winner-takes-all competition
      • Institutions will trade across borders for the best execution
      • Retail investors need to be able to do the same
      • This trend is already coming to fruition, as several retail brokerages offer fairly inexpensive trading throughout the EU
  • 25. Consolidation in the European ETF Marketplace
    • This winner-takes-all competition for liquidity will drive consolidation in the ETF marketplace
      • One or two “winners” will take the vast bulk of assets and trading volume for any given index to track
      • Despite having lower assets and not much growth, many smaller funds will remain alive on assets from in-house customers
    • Off-exchange distribution channels can not drive this consolidation
      • Liquidity and low trading costs are the draw of the top funds, and they do not carry over to off-exchange distribution
  • 26. Product Innovation Will Continue
    • New entrants in a more mature market can only compete on low costs or product innovation
    • Plenty of new areas ripe for expansion
      • Fundamentally-weighted indices
      • Screened indices
      • Active ETFs
      • Funds of hedge funds
      • “ Alternative beta”