ETF development is fired up by commodities interest

Dutch bank ABN AMRO entered the exchange traded fund (ETF) business this summer with the listing on Deutsche Börse of its Market Access Jim Rogers International Commodity Index (RICI) Fund. It will not be the last asset manager to enter the market, but new issuers are the least measure of ETFs’ extraordinary growth. First-time users are multiplying and old hands are increasing their exposure. As assets under management (and this is not hyperbole) soar, both numbers and types of funds are proliferating.

ABN AMRO has plans for a series of Market Access products, offering exposure to property, emerging markets (such as Brazil and India) and more commodities, including RICI-based agricultural and base metals funds. It also intends to roll them out across European stock exchanges, starting with SWX and Borsa Italia. In doing so, the bank reflects some of the current themes in the ETF industry.

Product development

In equities, the ETF’s mother country, product development has embraced emerging markets and evermore detailed sector segmentation and is moving on to more synthetic indices with a whiff of active management. In the non-equity universe, new funds are offering easier access to fixed income and property, currencies and commodities – although the vehicles are not always orthodox ETFs. Whatever they track, stock exchanges are as keen to list them as investors are to trade them.

True ETFs are usually open-ended index funds whose shares are listed on stock exchanges and traded all day, just like other equities. They give investors exposure to assets, countries or sectors that may be difficult to acquire in other ways. They are cheap to trade, with no front-end loading and low expense ratios, and because their holdings are disclosed daily, they are transparent.

Flexible options

ETFs can be traded in relatively small sizes and can be sold short – in the US they are even exempt from the uptick rule that forbids shorting a stock when its price is falling. And they can be lent, which makes them rather attractive to certain institutional investors. “The lending revenue that can be earned on ETFs can, at times, more than cover the annual total expense ratio,” says Deborah Fuhr, Morgan Stanley’s widely-respected ETF strategist.

That is made easier by the fact that total expense ratios (TERs) continue to fall. In Europe, Ms Fuhr says, they now average 46 basis points (bp) for equity ETFs and 17bp for fixed income products. That compares with 100bp and 109bp respectively for European equity index and fixed income funds, according to investment researcher Fitzrovia. In the US, where issuers continue to reduce fees, the difference can be even more compelling. The iShares S&P 500 Index Fund, for example, has a TER of 9bp, compared with a 75bp average for passive or indexed mutual funds.

These features have combined to fuel the (so far) unstoppable rise of the ETF sector. By the end of June 2006, Morgan Stanley was able to count 596 ETFs worldwide, with assets of $487.1bn, managed by 64 managers on 36 exchanges. The assets had grown by 16.9% since the start of the year, somewhat faster than the 4.9% dollar rise in the MSCI World benchmark. And they are not stopping there. Morgan Stanley forecast that ETF assets would top $2000bn by 2011.

First half growth was on fire in Europe, where assets increased by 29.9% to $71.3bn, compared with 13.2% growth in the US ($344.4bn) and 24.5% in Japan ($39.5bn), where ETFs have yet to catch on with retail investors.

Around 150 new funds have been launched already this year, compared with 119 in the whole of 2005, and Morgan Stanley's Ms Fuhr estimated in August that another 177 were waiting in the wings – 60 in Europe, 92 in the US and 25 on exchanges in the rest of the world, including China, India, Singapore, Taiwan and Israel.

As the listings and the assets grow, so do trading volumes. “Last year, we averaged €3.8bn in monthly volumes,” says Richard Willis, a spokesman for Deutsche Börse, which lists the largest number of ETFs and accounts for half of ETF on-exchange turnover in the products among European exchanges. “In the first quarter of 2006, that rose [by 47%] to €5.6bn. So the curve is going up on both fronts.”

Euronext has the second largest share of the European market, with about 22%. The London Stock Exchange (LSE) has 11%, hobbled by the fact that, unless an ETF is registered in Dublin, trading in its shares attract stamp duty. “ETF trading has to be extremely cheap,” says David Shrimpton, the LSE’s head of product management. “A 50bp distortion on purchases is too much, and an impediment to other issuers coming to the UK market.”

David Shrimpton: ETF trading has to be cheap Nonetheless, London’s 2006 month-on-month trading volumes have doubled compared with 2005, rising to about £1.5bn in May.

Big issuers in London

By far the dominant issuer among London’s 34 ETFs (all Dublin-registered) is Barclays Global Investors (BGI), which also happens to be the largest ETF manager worldwide. Its 166 funds, branded iShares, accounted for $231.6bn in assets at the end of June, according to Morgan Stanley – 48% of the worldwide total. State Street Global Advisers, with its streetTracks products, ranked second, with $96.2bn in 60 funds. Bank of New York came a distant third with $28.7bn in six funds.

BGI has nearly 58% of the US market, with just over $200bn in assets. In Europe, it recently overtook its two major competitors to become the biggest player there too, with nearly $18bn under management at end-June and 25% of the market. HypoVereinsbank's IndEXchange and Société Générale's Lyxor Asset Management, the previous market leader, were neck and neck with $16.9bn and $16.8bn respectively.

Search for exposure

More fund managers are accepting that, in a complex investment universe, they lack both time and skills to add value across multi-asset portfolios. So more of them are concentrating on what they know best and are using alternatives such as ETFs to gain exposure to markets or sectors with which they are less familiar. Others use them to equitise cash, or to establish overweight or underweight positions.

“There is now a lot more ETF product choice,” says Chris Sutton, iShares CEO for Europe and Asia ex-Japan. “So more people can use them for more strategies – exposure to emerging markets, for example.”

Chris Sutton: product choice is greater

Reinforcing that is an uncertain, low-yield environment in which money managers and private bankers are forced to look further afield for new markets and asset classes. Hence the growth in emerging market ETFs, notably in China and eastern Europe indices. “Now that markets are no longer growing at 20% a year, another driver in ETFs’ favour is that people are looking more closely at value for money,” adds Mr Sutton.

Money magnet

The fund that has attracted the most money this year is the iShares MSCI EAFE fund. In the first half it took in $5.5bn to make a total of $28.7bn. It was followed by streetTracks Gold Trust, which attracted $3.1bn, boosting it to $7.4bn. The Spider S&P 500 remains the largest and most actively traded fund, and the Nasdaq-100 Index fund is usually near the top on both counts. But iShares MSCI Emerging Markets is now among the top 10 biggest and busiest funds.

A variety of emerging markets indices is now tradeable in ETF form. Some of the less obvious include Brazil, Israel, Malaysia, Mexico and South Africa, alongside eastern Europe with or without Russia. Planned ETFs will provide access to Turkey and a BRIC (Brazil, Russia, India, China) portfolio.

Sectoral indices have not been overwhelmingly popular in Europe. In the US, however, they are becoming evermore focused. Funds have been launched to track utilities, housebuilders, semiconductor makers and ‘clean’ energy (there is also a fund that tracks IPOs). One planned family of 12 medical funds from Ferghana-Wellspring will shadow indices such as diagnostics, central nervous system, cancer (two funds), and derma and wound care. A US investor-blogger was moved to observe: “That is some narrow action.”

Two-pronged growth

What next? “ETFs are growing in two directions,” says Cliff Weber, senior vice-president ETF Marketplace at the American Stock Exchange (Amex), which listed the first ETF in 1993. “The first is in alternative and non-equity assets, primarily commodities, but also currencies, fixed income. Then we are seeing more strategy-based or theme-based ETFs – like our Intellidex funds, based on quantitative indices that are designed to outperform.”

That is otherwise known as stockpicking, and Amex has plans to move more aggressively into the realm of active management. “We have spent a fair amount of time working to create a framework for truly actively managed funds to trade as ETFs,” Mr Weber says.

ETFs disclose their holdings every day, which is something that active managers do not want to do, for fear of front-running or ‘free-riding’. Amex has developed a method that allows investors to hedge active products without the fund manager having to disclose holdings fully, says Mr Weber. “We have found a way to bridge that gap. We have a patent and you may see something some time next year.”

As commodities become a more mainstream portfolio interest, more ETF-type vehicles are emerging. A silver fund from BGI caused a stir recently, and managed to move the market in the metal itself. Gold and oil funds have attracted considerable interest, and the range of commodities available is due to expand. In London, ETF Securities has announced the imminent listing of an astonishing 29 so-called exchange traded commodities (ETCs), based on Dow Jones-AIG commodity indices. Though technically not ETFs, they will give investors similarly easy access to assets as varied as aluminium, coffee, heating oil and ‘lean hogs’.

Other innovations can be expected, although they will tend to follow the wider world of investment management. It is hard to fault Chris O’Brien, S&P vice-president for European sales and marketing, when he insists: “ETFs are definitely here to stay.”