NO 235 – SEPTEMBER 2012
52nd WFE Annual Meeting

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WFE Focus September 2012
ETFs AND ETPs: WHY ARE THEY ONE OF THE FASTEST GROWING INVESTMENT PRODUCTS?
DEBORAH FUHR

Partner, ETFGI

Exchange Traded Funds “ETFs” and Exchange Traded Products “ETPs” assets reach a new high of USD 1.7 billion

Global assets invested in Exchange Traded Funds (ETFs) and Exchange Traded Products (ETPs) hit an all-time high of over USD 1.7 trillion (USD 1,762 billion) at the end of August 2012. Year-to-date through end of August 2012 ETF and ETP assets have increased by 15.5% from USD 1,526 billion to USD 1,762 billion.

Market volatility may be making investors wary about the stock market, but they continue to find exchange-traded funds and other exchange traded products useful tools.

Over the past 10 years the compounded annual growth rate (CAGR) of these products globally has been 26.5%. There are currently 4,713 ETFs and ETPs, with 9,620 listings, assets of USD 1,762 billion, from 204 providers on 56 exchanges.

The challenging market conditions currently and over the past few years, combined with the difficulty in finding active managers that consistently deliver alpha, have caused investors to embrace the use of ETFs and ETPs. ETFs provide greater transparency in relation to costs, portfolio holdings, price, liquidity, product structure, risk and return compared to many other investment products and mutual funds.

ETFs are typically open-ended, index-based funds, with active ETFs accounting for less than 1% market share. They can be bought and sold like ordinary shares on a stock exchange and offer a broad exposure across developed, emerging and frontier markets, equities, fixed income and commodities. ETFs are used widely by institutional and increasingly by financial advisors and retail investors to:

  • equitize cash
  • implement diversified exposure to a market
  • comprise a core or satellite investment
  • be a long term strategic investment
  • implement tactical adjustments to portfolios
  • use as building blocks to create entire portfolios
  • allow investors to hedge the market
  • use as an alternative to futures and other derivative products

Capital flows this year within ETFs also demonstrate how these products have become important indicators to gauge shifts in investor sentiment between and among asset classes. Year to date through end of August 2012, ETFs and ETPs saw net inflows of USD 143 billion which is USD 23 billion above the level of net new assets at this time last year. Equity ETFs and ETPs have gathered the largest net inflows accounting for USD 76 billion, followed by fixed income ETFs and ETPs with USD 47 billion and commodity ETFs and ETPs capturing USD 10.5 billion.

Fixed Income ETFs and ETPs have also proven to be very popular this year with USD 47 billion in net new assets, which is USD 1 billion more than the total new assets they received last year. Within the Fixed Income universe corporate bond products have gathered the largest net inflows with USD 18.5 billion, followed by high yield products with USD 11 billion and broad/aggregate bond exposures with USD 4.9 billion.

Equity focused ETFs and ETPs have gathered USD 76 billion which is USD 7 billion more than this time last year. Products providing exposure to the United States/North American equities have gathered USD 39 billion, followed by emerging market equity with USD 22 billion and Asia Pacific equity with USD 7 billion.

Commodity flows at USD 10.5 billion are slightly lower than this time last year. Precious metals have gathered the largest net inflows with USD 9.5 billion, followed by broad commodity with USD 1.3 billion and energy with USD 901 million. Agriculture experienced the largest net outflows at USD 1.2 billion.

In a world in which new financial products come and go in the blink of an eye, ETFs might well be considered the leading financial innovation of the past two decades.

Some history

The first stock market index was created in 1896 by Charles Dow, which became the Dow Jones Industrial Average. In 1975 Charles Ellis highlighted the shortfall of active managers in his often referenced article ‘The Loser’s Game’ published in the Financial Analysts Journal, July/August 1975. He reported that over the prior decade 85% of all institutional investors who tried to beat the stock market underperformed the S&P 500 Index. The first indexed mutual fund was launched in the United States in 1975.

The challenge of finding professional managers who consistently beat their benchmark – as measured by the S&P 500 index - and delivered alpha by picking individual stocks has not changed much in the past nearly forty years. An index fund may not offer the potential to outperform a benchmark, but you do know you will get the benchmark minus fees and any tracking error, which should be very small.

In 2011, 81% of active large-cap managers underperformed the S&P 500, according to the S&P Indices Versus Active Funds report. Even changing the look-back period of the asset class makes little difference to the results. For the five years ending March 2012, only 5.23% of large-cap funds, 5.46% of mid-cap funds and 5.14% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods.

Although there are a range of factors that wealth managers need to consider when looking at how to use exchange traded funds (ETFs) in their portfolios, it is important first of all to pinpoint what exactly an ETF is, dispel some of the myths, and highlight the benefits they can offer.

ETFs have become popular and widely used investment vehicles. In a world in which new financial products come and go in the blink of an eye, ETFs might well be considered the leading financial innovation of the past two decades.

Since the first fund was launched in Canada in 1990, ETFs have opened a new panorama of investment opportunities. They have fundamentally changed how both institutional and retail investors construct investment portfolios. Essentially, they are index funds (a few ETFs have been launched that are not designed to track an index) that are listed and traded on exchanges like stocks. They also allow investors to gain broad exposure to specific segments of equity markets with relative ease, on a real-time basis, and at a lower cost than many other forms of investing.

ETFs are based on sector, large cap, mid cap, small cap, value, growth, domestic, international country and regional equity indices, commodity, currencies as well as on corporate, credit, inflation and government fixed income indices. Typically they can be used to short indexes, are lendable, and are purchased on a commission basis just like other equities.

We believe that growth in the use of ETFs reflects their many advantages. They trade throughout the day on major securities exchanges and can be bought and sold using market, limit, or stop orders.

ETFs are funds, not derivatives, which allow investors to quickly react to short and long-term requirements or opportunities. As such, they may serve as an alternative to futures, trading baskets of stocks and traditional mutual funds.

ETFs do not have any sales loads, although like mutual funds, they do have annual expense ratios – albeit less than traditional funds, ranging from 0.05% to 1.6%. In fact, ETFs have some of the lowest total expense ratios among registered investment products. Recent interest from individual investors has been partly fuelled by attempts to avoid accounting, earnings, and other stock-specific risks.

ETFs provide daily portfolio transparency, are listed and traded on exchanges like stocks on a secondary basis as well as utilising a unique creation and redemption process for primary transactions.

But these vehicles also have distinctive features, with each ETF designed to track a specific index (note there are a small number of Active ETFs which account for less than 1% of the global assets). They provide access to investment styles, asset classes, markets and different sectors.

Most ETFs purchase the underlying securities in the index with the majority fully replicating their underlying index, and many have the capacity to employ optimisation and sampling techniques. These ETFs may exclude certain securities and deviate from their benchmark constituent weights, which could lead to tracking error.

The open-ended structure typically allows funds to lend stock, which may generate extra income. In addition, these funds can hold other securities and financial instruments, including cash and equivalents and futures.

Dividends are typically paid out quarterly, semi-annually or annually, although some ETFs do reinvest dividends in the fund.

In Europe, a new synthetic approach is increasingly being used to create funds and ETFs rather than the physical approach which is the predominant form in the US and many other jurisdictions around the world.

Synthetic ETFs utilise a total return swap plus a basket of securities to comply with the diversification rules under Ucits to deliver index performance rather than purchasing the underlying securities in the index. At the end of August 2012, the global ETF industry had 3,322 ETFs, with 7,507 listings, assets of USD 1,573 billion, from 174 providers on 51 exchanges.

According the recent ETFGI Monthly Insights report at the end of August 2012, of the 1,327 ETFs in Europe, 507 ETFs (38.2%) used physical replication while 813 ETFs (61.3%) were synthetically replicated. In terms of assets, of the USD 295 billion in total ETF assets at the end of August 2012, USD 186 billion (63.0%) was held in physical ETFs compared to USD 109 billion (36.9%) in synthetic ETFs.

Physical ETFs have experienced net inflows of USD 13.2 billion year to date 2012 through the end of August compared to net inflows of USD 394 million into synthetic ETFs according the recent ETFGI Monthly Insights report based on data at the end of August 2012.

The focus of this debate has largely narrowed to a battle between physical and synthetic providers centring on the relative risks of counterparty exposures in physical funds with lending programmes versus synthetic replication techniques.

it is surprising that the risks posed globally by unregulated ETPs – which make up 10.7% of the USD 1.7 trillion invested in combined ETF/ETP universe and 29.5% of the 4,713 products at the end of August 2012 according to the ETFGI Monthly Insights report – are not afforded a higher priority.

However, it is surprising that the risks posed globally by unregulated ETPs – which make up 10.7% of the USD 1.7 trillion invested in combined ETF/ETP universe and 29.5% of the 4,713 products at the end of August 2012 according to the ETFGI Monthly Insights report – are not afforded a higher priority.

It is important to remember that when we look at counterparty exposure across ETFs and ETPs the associated risks from an investor perspective are significantly different depending on the type of investment vehicle and the level of regulation associated with it.

For the investor purchasing through his brokerage account, however, these products all trade and settle in an identical fashion and the varying degree of risk and counterparty exposure will not be immediately apparent.

In this context, it is worth reminding ourselves that for all the vigorous debate within the ETF community, we are talking about exposures within a highly regulated investment funds framework.

While there may be concerns around the quality and liquidity of swap collateral and liquidity, or the robustness of a securities lending programme, it is important not to lose sight of the fact that from an investor’s perspective, their investment is through a highly regulated entity and any and all exposures have strict parameters.

The important and ongoing debate around systemic risk as opposed to investor concerns in fund products should not detract from the fact that the investment itself is well protected in its fund wrapper.

The important and ongoing debate around systemic risk as opposed to investor concerns in fund products should not detract from the fact that the investment itself is well protected in its fund wrapper.

Once we look to investment in non-fund ETPs we see that there is effectively no regulation either of the investment exposure itself or the delivery mechanism of that exposure.

The most common non-fund ETP exposure is through a debt security. This structure may vary from a simple note programme issued by a bank where an investor has, in addition to his investment risk, 100% exposure to the issuing bank, to more complex structures utilising special purpose vehicles and collateralisation programmes. These ensure effective segregation of assets between different types of exposure – an automatic feature of fund structures – and the elimination of counterparty risks.

As unregulated structures however, it is incumbent on the investor to ensure he or she understands those risks and the mitigating factors the promoter introduces (or, more pertinently, does not introduce).

Increasingly investors are asking how to select an ETF given the breadth and depth of products available in the market. When considering ETFs it is important to assess that firstly it is an Exchange Traded Fund structure as often other types of exchange traded exposures are called ETFs which can imply different tax and regulatory treatment.

Step one: Identify the type of exposure you want to implement

Step two: Select a benchmark or index that best represents the desired exposure

Step three: Analyse the costs associated with using various ETFs.

The total expense ratio (TER) is the figure most commonly used to measure the annual cost of owning an index fund or ETF. Nonetheless, it is important to remember that it does not actually represent the complete cost of owning a fund or ETF.

Costs will also include a number of additional factors such as the bid/ask spreads, commission to buy and sell the ETF, transaction costs inside the ETF. This includes the cost of using swaps in the fund, minus any securities lending revenue paid to the ETF.

ETFs are low cost, transparent, secure and flexible investment, which have many uses in an individual or institutional portfolio.

Tracking error (TE) TE is the standard deviation of the difference in returns between a fund and the relevant benchmark measured over a period of time. It is a statistical measure which carries probabilistic characteristics. TE describes the distribution of the differences in returns, as opposed to an absolute measurement of return differences.

Step four: This is where you narrow down the list of products that can be used by reviewing factors such as the level and type of counterparty exposure, if the ETF is Ucits-compliant, the domicile/regulatory regime, the assets under management and tax regime as well as the reputation of the ETF or index fund provider.

An on-going and growing challenge is the need for education on and ability to access impartial information on ETFs, ETPs to compare them to other investment products and to dissipate some misunderstandings that may persist.

The number of investors will increase as will the ways ETFs are used, the types, the size of investment and the holding period.

ETFs are low cost, transparent, secure and flexible investment, which have many uses in an individual or institutional portfolio as detailed above. They are a very democratic product offering the same tool box of exposures, at the same costs and same minimum size to both institutional and retail investors. Once investors try ETFs once, they tend to use them in more ways, in larger sizes and hold them for longer periods.

We expect the industry to continue to grow in AUM based on the use of ETFs continuing to expand in the institutional, financial advisor and retail segments of the market globally. The number of investors will increase as will the ways ETFs are used, the types, the size of investment and the holding period.

About ETFGI

ETFGI is a wholly independent research and consultancy firm providing services to leading global institutional and professional investors, the global exchange traded fund and exchange traded product ecosystem, its Regulators and its advisers.

Founded in 2012 by ETF and ETP strategist, Deborah Fuhr and partners, ETFGI produces extensive ETF-specific analysis covering over 4,700 ETFs and ETPs, across 9,500 exchange listings.

ETFGI LLP leverages extensive industry experience, unparalleled industry contacts and rigorous analysis to deliver proprietary research on the global ETF and ETP industry.

ETFGI provide services to both new and experienced institutional and professional investors interested in using ETFs and ETPs and better understanding the industry, product, regulatory and company specific data points.

ETFGI offer a full range of consulting services covering the spectrum of the exchange traded exposure universe from data and analytics to product structuring, due diligence on products and service providers, from distribution and capital market challenges to governance and the regulatory environment.

This commentary is published by, and remains the copyright of, ETFGI LLP (“ETFGI”). This commentary may only be used by the permitted recipients and shall not be provided to any third parties. ETFGI makes no warranties or representations regarding the accuracy or completeness of the information contained in this commentary.

ETFGI does not offer investment advice or make recommendations regarding investments and nothing in this commentary shall be deemed to constitute financial or investment advice in any way and shall not constitute a regulated activity for the purposes of the Financial Services and Markets Act 2000. Further, nothing in this commentary shall constitute or be deemed to constitute an invitation or inducement to any person to engage in investment activity. Should you undertake any such activity based on information contained in this commentary, you do so entirely at your own risk and ETF Global Insight shall have no liability whatsoever for any loss, damage, costs or expenses incurred or suffered by you as a result.