Exploring trends in the ETF market

Since the first ETF was launched in the US in 1993, ETFs have opened up a vast number of investment opportunities. At the same time, the growth of the ETF market has grown significantly as the chart below reveals (see Figure 1). If forecasts made by research bodies such as Edhec and Morgan Stanley are accurate, this remarkable growth is set to continue. Deborah Fuhr of Morgan Stanley predicts that total ETF assets under management globally will exceed $2,000bn (E1,275bn) by 2011. In what follows, we hope to explore some of the trends that have driven the recent rapid growth of ETFs. Growing appreciation of benefits Beyond trends however, the biggest driver of ETF growth has been the growing appreciation of their benefits by investors including wealth managers:

• Transparency – investors know exactly which securities are held by the fund at any given time.
• Flexibility – ETFs are listed on stock exchanges and can be traded at any time the market is open, meaning investors access continuous, real-time prices throughout the day.
• Diversification – ETFs provide immediate exposure to a diversified portfolio of securities, while also providing access to a wide range of markets and asset classes that can help to diversify an existing portfolio
• Easy to use – ETFs are potent tools which are traded over the stock exchange, meaning that investors can buy and sell ETFs exactly as they would trade local shares – no additional operational setup is required, as is often the case with derivative products.
• Liquidity – The unique primary and secondary market mechanism ensures that ETFs are highly liquid, and that liquidity will always be available for investors looking to buy or sell ETFs
• Cost effective – ETFs offer a cost effective route to diversified market exposure. The average total expense ratio (TER) for equity ETFs in Europe is 49 bps, while the average TER for the average equity mutual fund in Europe is 120 bps (Fitzrovia 2006).

As the job of most portfolio managers on behalf of wealthy clients has become broader and deeper, covering all the developed and emerging markets as well as looking at sectors and countries, the Deborah Fuhr Morgan Stanley report recently revealed that many are admitting that they do not have the time nor resources to try to add value in all markets and are embracing the use of ETFs to gain international market exposure. This allows them to pick stocks in the markets that they feel can they can add value in. An easy way to gain beta In other cases, these ETFs are used to equitise cash or to establish an over or underweight position. ETFs make it easier for investors to participate in all domestic asset classes, global regions and industry sectors. Most importantly, ETFs give investors the opportunity to participate where markets have been showing promise. Investors are increasingly using ETFs to easily gain beta exposure to international and emerging market benchmarks in order to have more time to capture alpha by selecting stocks in markets where they feel they can add value - the “asset management barbell”. ETFs listed in the United States providing exposure to international and emerging market equity benchmarks saw their assets grow in 2007 by 58.9 per cent while ETFs focused on the US market grew by 33.9 per cent. Key themes The trends being witnessed are likely to continue and to look deeper they centre on the following key themes. Firstly, wealth managers who choose to use ETFs view them as useful tools for both tactical and strategic exposure. For example, they are increasingly using them with a core satellite investment approach. This means dividing the portfolio into a core component, which is passively managed and which aims to fully replicate the investor’s specifically designed benchmark, and an active component, which is made up of one or several satellites of active managers, who are allowed to have a higher level of tracking error. The core portfolio can be typically made up of a pure index product, such as an ETF. We are also seeing that ETFs are increasingly finding a place as satellites as the range of asset classes available through ETFs increases. An investor, for example, might add exposure to listed property as a satellite to a core portfolio of European stocks and bonds by using an ETF. The expansion in asset classes and the number and types of equity, fixed income and commodity and other indices covered by ETFs is also a major attraction to investors. This is happening very quickly, and it is rare for a week to pass without a new ETF launch. For example, the recent launch of an iShares JPMorgan $ Emerging Market Bond fund in the UK has ignited significant interest. It has raised over £200m (E250m) in assets since its launch in February this year, reflecting the continued demand from investors for emerging market exposure and in search of funds that can access hard to reach sectors and places. ETFs are ideal for this. A closer working relationship ETF and index providers are increasingly working closer together to ensure that they develop cost effective, sound ETF solutions and consistent product themes allowing investors to efficiently diversify their portfolios in today’s rapidly changing market environment. By working together, new index concepts can be engineered to deliver robust and smart diversification tools that meet investors’ needs. Given the growth expectation this looks set to continue to even greater effect. Passive, index-based investing in general is also gaining favour as investors begin realistically assessing the costs and benefits of active investing. Without a doubt, there are excellent active managers in the market – but there is significant cost involved – not just the actual fees of the active fund, but also the costs of researching and monitoring good active managers. Where investors are simply looking for exposure to a market as a whole, passive investing through ETFs is often the most efficient approach from a risk and cost perspective. Potential for further growth There is also still huge potential for further growth in the European ETF space. The European market is more diverse than the US market, with a wide variety of competing products, from certificates and structured products to traditional mutual funds. BGI believes that ETFs offer distinct advantages, and will continue to capture flows from these products. These trends look set to continue and are supported by a European research study carried out by Edhec in partnership with iShares. The findings included 55 per cent of 110 respondents in the asset management survey said that the use of ETFs will increase in the near future while only 34 per cent had the same opinion about futures, a popular form of index derivative. Concerning the main future development areas for ETFs, a wide majority of survey respondents quoted emerging markets (49 per cent), commodities (36 per cent) and more broadly, alternative asset classes (41 per cent). Furthermore, the research revealed that while asset managers and investors are well aware of the advantages of ETFs, they have yet to take full advantage of them. As investors begin to explore the potential of ETFs - for example with a core satellite approach – we believe that usage will increase significantly. In Europe as a whole, ETFs are poised for incredible growth.