Talking Point

www.etfiasia.com

ETF industry: following the mutual fund playbook?

Too much of a good thing could become bad
By Imran Ahmed Others, such as the US$1.2 billion United States Oil Fund ETF (USO) use synthetic investment strategies to achieve their investment objective.5 To be sure, the above list is not comprehensive nor is it meant to capture all the nuances which exist within todays ETF industry. Nonetheless, the list does speak to the proliferation of ETF varieties amidst a gradual shift away from the traditional full replication ETF. In fact, the ETF industry has moved into a stage where ETFs of ETFs have come into existence, the latest of which is expected to be the iShares Morningstar Multi-Asset High Income Index Fund. iShares recently filed paperwork for the ETF with the US Securities and Exchange Commission (SEC). According to the documents, the ETF will invest in other ETFs to achieve its target asset allocation of fixed income (60%), equities (20%) and real estate investment trusts / preferred stocks (20%).6 Fund of funds are part of a script investment managers have seen before. In its heyday, the mutual fund industry saw similar enthusiasm: creative vehicles to package mutual funds sprouted like weeds in an untended garden. However, as investor awareness about the benefits of mutual funds became better known most mutual funds fund of funds disappeared. Currently, the ETF industr y is dominated by three main players: BlackRock, State Street Global Advisors and Vanguard. According to January 2012 data compiled by the ETF Industry Association 7, these three ETF issuers control approximately 83% of the entire ETF market of US$1.2 trillion (see table). It is interesting to note that success in the mutual fund industry does not necessarily translate into ETF triumphs. Fidelity, a household name in mutual funds, had only US$177 million in ETF assets.8 The ETF Industry Association data lists a total of 44 ETF issuers, i.e. the remaining 17% or approximately US$196 billion is shared by 41 issuers. Arguably, at average

ew will argue with the idea that exchange traded funds (ETFs 1) are a positive development for global capital markets. For investors, ETFs have reduced the fee structure for numerous investment products, e.g. mutual funds. Additionally, ETFs have dramatically increased investment flexibility for investors by making many asset classes more easily accessible to a broad spectrum of investors. For issuers, an entirely new fee generating industry has emerged. For brokers, ETFs have attracted a new class of investors into international securities markets investors which until now may have stayed away from investing directly into listed securities. However, ETFs are no exception to conventional wisdom that too much of a good thing becomes a bad thing. So, have ETFs already reached the too much stage and how will the ETF industry evolve following its rapid expansion of recent years. ETFs have grown from simple index replication strategies into a complex industr y involving many different

description of a selection of nonreplication ETF types: 1. Synthetics: ETFs that utilise derivate products to track the performance of certain indices or asset classes. The US$2 billion PowerShares DB Agriculture ETF (DBA), designed to track the price performance of a basked of agricultural commodities is an example of a synthetic ETF; 2. Inverse: ETFs which attempt to return the inverse or opposite of a particular asset class or index. The US$2.1 billion ProShares Short Standard and Poors 500 ETF (SH) which seeks daily investment results, before fees and expenses, which correspond to the inverse (opposite) of the daily performance of the S&P 500. 2 Note that most inverse ETFs are also synthetic ETFs; 3. Ultra return: ETFs which use derivative securities in an effort to achieve double the return of a set benchmark. These ETFs are synthetic and can also be inverse, e.g. the US$2 billion ProShares UltraShort Standard and Poors 500 ETF (SDS). SDS seeks

As investor awareness about the benefits of mutual funds became better known most mutual funds fund of funds disappeared
constructs and strategies. The initial ETF type was a full replication structure. A full replication ETF typically invests in exactly the same securities and in the same proportion as the index the ETF is designed to follow. Thus, full replication ETFs generally have low tracking error and are useful vehicles for investors seeking beta exposure to particular indices. However, in recent years, nonreplication ETF arrangements have become fairly common. Below is a 16 ETFI ASIA 2012 Q1 daily investment results, before fees and expenses, which correspond to twice (200%) the inverse (opposite) of the daily performance of the S&P 500.3 4. Commodity and Currency: ETFs which are designed to track the returns of a particular commodity or currency. Some of these, such as the US$71.3 billion SPDR Gold Shares ETF (GLD), which tracks the price performance of gold, use a replication strategy, e.g. by investing directly in physical gold.4

www.etfiasia.com

Talking Point
Top 10 ETFs
Issuer 1 SPDR S & P 500 (SPY) 2 SPDR Gold (GLD) 3 Vanguard MSCI EM (VWO) 4 iShares EAFE (EFA) 5 iShares MSCI EM (EEM) 6 PowerShares (QQQ) 7 iShares S & P 500 (IVV) 8 iShares Barclays TIPS (TIP) 9 Vanguard MSCI Total Market (VTI) 10 iShares Inv. Grade Corp. Bond (LQD) Total ETF Industry Assets
* Month end January 2012 Source: ETF Industry Association

management fees of slightly over forty basis points 9, issuers walk away with almost US$800 million in management fees. Moreover, that figure does not include any ancillary fees associated with sponsoring the ETF. Theoretically, therefore, the pie is big enough for many issuers in a long tail of ETFs. However, there are two parts to the consolidation story: at the issuer level and at the ETF fund level. At the ETF level, the concentration is also high. The top ten ETFs, with assets of almost US$420 billion, account for just over one third of all ETF assets. At the end of 2011, there were 1,370 US listed ETFs, an increase of 25% over the previous year. Of these 1,370 funds, less than half or 501 ETFs had assets of over US$100 million.10 Since the launch of the SPDR

Total Assets (US$ millions)* 99,008 71,245 49,783 38,490 37,428 31,020 28,078 23,119 20,652 18,544 1,150,370

Percentage of ETF Industry 9% 6% 4% 3% 3% 3% 2% 2% 2% 2% 36%

Top 10 ETF Issuers

Issuer 1 2 3 4 5 6 7 8 9 10 BlackRock SSgA Vanguard Invesco / PowerShares Van Eck ProShares Wisdom Tree Deutsche Bank Rydex Direxion Total ETF Industry Assets
* Month end January 2012 Source: ETF Industry Association

Total Assets (US$ millions)* 483,530 287,598 187,276 51,525 26,219 22,456 13,662 12,150 8,159 7,235 1,150,370

Percentage of ETF Industry 42% 25% 16% 4% 2% 2% 1% 1% 1% 1% 96%

Standard and Poors 500 ETF (SPY) in January 1993 the ETF industry has grown in leaps and bounds. Total assets at US$1.1 trillion have surpassed the total foreign exchange reserves of all but two nations, China and Japan. The number of ETFs has expanded to almost 1,500 individual funds. This positive growth of the ETF industry will continue for many more years, especially as investors continue to substitute mutual funds with a cheaper ETF alternative. However, as ETFs nears their third decade of existence, industry growth rates will surely moderate at some stage. Slowing growth will create opportunities for consolidation at both the industry and fund level as participants attempt to attain economies of scale.

1 2

For the purposes of this article, the generic term ETF refers to exchange traded portfolios comprised of various structures, including exchange traded notes (ETNs). Yahoo! Finance accessed on February 11, 2012. http://finance.yahoo.com/q/pr?s=SH+Profile Yahoo! Finance accessed on February 11, 2012. http://finance.yahoo.com/q/pr?s=SDS+Profile Yahoo! Finance accessed on February 11, 2012. http://finance.yahoo.com/q/pr?s=GLD+Profile Yahoo! Finance accessed on February 11, 2012. http://finance.yahoo.com/q/pr?s=USO+Profile iShares plans Multi-Asset Fund-of-Funds ETF by Alex Ulam and Olly Ludwig. February 6, 2012. Accessed on February 15, 2012. http://www.indexuniverse.com/sections/news/10961-ishares-plans-multi-asset-fund-of-funds-etf.html?utm_source=newsletter&utm_medium=email&utm_campaign=IndustryNews ETF Industry Association accessed on February 15, 2012. http://www.etf-ia.com/ ETF Industry Association accessed on February 15, 2012. http://etf-ia.com/sites/all/themes/etfia/downloads/Jan-2012-ETF-Data-Summary.pdf Based on a Deutsche Bank study, In the ETF Labyrinth, Where Does the Thread Begin? by Christos Costandinides and Daniel Arnold as quoted in ETF Providers Earn Double Funds Management Fees by Paul Amery, July 10, 2011 accessed on February 15, 2012. http://www.indexuniverse.eu/europe/opinion-and-analysis/7904-etf-providers-earn-double-funds-management-fees-says-deutsche-bank.html 2011 Recap: Another Big Year for ETFs by Michael Johnston, January 9, 2012 from the ETF Database website. Accessed on February 15, 2012. http://etfdb.com/2012/2011-recap-another-big-year-for-etfs/

10

ETFI ASIA 2012 Q1 17