ETFs - Past, Present, Future


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  • ETFs - Past, Present, Future

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