Since their creation in Canada in 1989, exchange traded funds (ETFs) have opened a new panorama of investment opportunities. Essentially, ETFs are index funds that are listed and traded on exchanges like stocks; they allow investors to gain broad exposure to entire stock markets of different countries and specific sectors with relative ease, on a real-time basis and at a lower cost than many other forms of investing. ETFs also can be used to short an index - even on a downtick in the US. They can be purchased on margin, are lendable and are purchased on a commission basis just like any other US share.
Assets under management (AUM) invested in ETFs listed in the US have soared from two products with USD1.1bn in 1995 to 113 products with USD102.3bn at the end of 2002 (see Exhibit 1). They currently account for around 12% of all indexed mutual fund assets in the US and are among the most actively traded shares. January 29, 2003 marks the tenth anniversary of the first ETF listing in the US.
At the end of 1993 there were globally three ETFs trading on two exchanges with USD811m in assets (see Exhibit 2). At the end of 2002, globally there are 280 ETFs trading on 25 exchange platforms with 361 listings, AUM of USD141.6bn and an average daily trading volume of 143m or USD6.3bn during December. Although 2002 equity market performance was down for most major indices (in US dollar terms the MSCI World index was down 21.1%, MSCI Europe declined 20.1%, MSCI Far East was minus 11.9% and the S&P 500 declined by 23.4%) and the majority of traditional equity mutual funds suffered net outflows, AUM in ETFs increased by 35%, from USD104.7bn to USD141.6bn. AUM growth came from Japanese listed ETFs, which increased 218% (USD14.4bn) to USD21.0bn, followed by Europe, which had a 91% increase in AUM (USD5.1bn) to USD10.7bn, followed by the US, which increased by 21% (USD17.7bn) to USD102.3bn.
In 2002, there were 82 new ETFs launched, down slightly from 2001, when 110 new ETFs were launched. Europe had the largest number of new product launches - 47, an increase of 66% - and accounted for all 53 cross-listings during the year, followed by the US with 15 new product launches and Japan with 10.
In less than three years Europe has more products than the US, 118 products and 192 cross-listings with assets of USD10.7bn. This growth has been impressive when compared to the US where it has taken nine years to see the launch of 113 products and over four years to amass USD10.7bn in AUM (see exhibit 4). April 11, 2003 marks the third anniversary of the first ETF listing in Europe.
ETFs have become more popular with investors who want a flexible tool that is not a derivative to allow them to be able to react quickly to short-term needs or opportunities. They can be bought and sold at market, limit or as stop orders. They do not have any sales loads, although they do - like mutual funds - have annual, albeit less expensive, charges ranging from 0.0945% to 0.99%. In fact, ETFs have some of the lowest expense ratios among registered investment products. The annual expenses are deducted from dividend payments, which typically are paid-out on a quarterly, semi-annually or annual basis.
ETFs can be effective tools for both active and passive institutional managers and for retail investors. As such, they are an alternative to futures, program trades and the use of traditional active and passive funds. We have seen significant growth in the number of institutional investors reporting holding one or more US listed ETF or HOLDRS, rising to almost 1,200, from less than 500 two years ago.
The growth in the use of ETFs has been partially fuelled by investor's attempts to avoid accounting, earnings and other stock specific risk. Also, many investors believe that asset allocation is the primary driver of investment returns as demonstrated in a study conducted by Brinson, Hood and Beebower in 1987, which found that nearly 92% of the variation in pension fund returns were attributable to the asset allocation decision.
Investors now have a nearly complete toolkit given the array of 280 ETFs that are now available to track equity indices on a country, regional, or sector basis. Through the various index managers investors are now able to use ETFs for tactical country and sector allocation strategies. In this way they can follow overall movements in the market rather than risk exposure to individual stocks in a particular area.
Major players in the ETF market traditionally have been large institutional investors seeking to index core holdings or pursue more aggressive market timing and sector rotation strategies. However, since smaller institutions and retail investors can trade in small lots, they can invest on the same terms as larger investors. ETFs offer numerous applications, which can be appealing to institutional and retail investors. Benefits of this approach include:
- The ability to equitise cash flows. This can be done in relatively small increments - ETFs typically trade in round lots with the price of a share ranging from approximately USD7 to USD400. ETFs can be a good alternative to using futures to manage cash flows: they can be bought in smaller sizes than futures; they do not require any special documentation or accounts and investors do not have to worry about roll costs and margin requirements. In addition, ETFs covers many benchmarks for which there is no futures contract.
- Effective asset allocation. ETFs can be used to target sectors where there are no futures contracts. For settlement and administrative purposes, ETFs are a more efficient way of investing than purchasing a basket of individual stocks to track a given benchmark. They can also be a core holding in a multi-asset portfolio, providing a level of diversification that would otherwise be time consuming and expensive to attain by purchasing the underlying shares.
- Reducing portfolio risk. ETFs can form the core holding in a portfolio with the aim of reducing portfolio risk. A core holding can help to ensure that a portfolio's performance does not widely deviate from an established benchmark.
- Switching between sectors. ETF products can be used to implement sector rotation and sector allocation strategies. They can also be used to adjust sector or country exposure.
- Hedge a sector or country. ETFs can be used to hedge sector, country or regional exposure. They can be sold short to hedge a portfolio of stocks, allowing an investor to preserve a portfolio while protecting it from overall market losses.
ETFs settle just like any other shares on the exchange. They are transparent, as the fund manager discloses the underlying basket of shares to the market every day and unlike traditional funds are not subject to style drift. ETFs afford investors two forms of liquidity: 1) via the trading of shares on a secondary basis on the exchange and 2) via the 'creation' process where an 'authorised participant' or 'market-maker' purchases the underlying basket of shares in the local market and deposits the basket 'in kind' with the ETF manager in exchange for more shares in that ETF. The redemption process works in a similar fashion: the 'authorised participant' or 'market-maker' delivers ETF units to the ETF manager and takes delivery of the underlying basket of shares. This unique creation/redemption process means that the liquidity in the ETF is driven by the liquidity in the underlying shares.
Unlike closed-end funds, ETFs tend to trade at or close to the NAV of the underlying basket of shares. It is believed that there are arbitrageurs waiting to take advantage of significant premium or discount relative to the underlying index. An arbitrageur would typically buy or sell the ETF and place an offsetting buy or sell transaction in the underlying basket of component stocks or futures.
In the current uncertain economic climate, we can expect continuing growth in the demand for ETFs worldwide, with products likely to exceed 350 over the next two years. This means more managers launching ETFs, more exchanges listing them and total expense ratios continuing to fall. It also likely to mean we will see more ETFs on fixed income indices, with total ETF assets growing to well over USD200bn.
HOLDRs (Holding Company Depository Receipts) are not ETFs, although they are similar. HOLDRs differ in a number of important ways. They use a grantor trust structure - grantor trusts are not regulated under the Investment Company Act of 1940 - to create a static basket of typically 20 or 50 shares to provide thematic exposure to different market segments. HOLDRs do not track a benchmark and are never rebalanced. Over time, the lack of any rebalancing could cause the composition of the HOLDRs basket to become heavily concentrated in a few shares. Unlike ETFs, investors in HOLDRs are the beneficial owners of the underlying shares and thus directly receive dividends and company reports, and are responsible for voting the shares. There are 17 HOLDRs with an open interest of USD4bn at the end of 2002.
Table 1 ETFs around the world end-December 2001 to end-December
2002
Country (No. of managers) | Number of primary ETF listings | Total ETF listings | AUM (USDbn) | Change in no. primary ETF listings | Change in total listings | Change in AUM (USD) |
ETFs | ||||||
US (6) | 113 | 113 | 102.28 | 15/-3 | 15/-3 | 17.68 |
Europe (14) | 118 | 192 | 10.69 | 47 | 100 | 5.09 |
Japan (4) | 18 | 18 | 21.00 | 10 | 10 | 14.40 |
Canada (3) | 16 | 16 | 2.88 | 1/-1 | 1/-1 | -0.42 |
Korea (4) | 4 | 4 | 0.31 | 4 | 4 | 0.314 |
Australia (1) | 3 | 3 | 0.23 | 1 | 1 | 0.10 |
South Africa (1) | 3 | 3 | 0.554 | 2 | 2 | 0.24 |
Hong Kong (2) | 2 | 4 | 3.09 | 0 | 0 | -0.51 |
India (1) | 1 | 1 | 0.002 | 1 | 1 | 0.002 |
Israel (1) | 1 | 1 | 0.34 | 0 | 0 | -0.17 |
Singapore (1) | 1 | 6 | 0.18 | 1 | 1 | 0.184 |
ETF Total (28) | 280 | 361 | 141.6 | 82/-4 | 135/-4 | 36.92 |
HOLDRS (1) | 17 | 17 | 4.0 | 0 | 0 | 0.2 |
ETFs & HOLDR Total | 297 | 378 | 145.64 | 82/-4 | 135/-4 | 37.14 |
Source: Morgan Stanley Research and Bloomberg. Data as of December 31, 2002. Note: a minus indicates an ETF which has been delisted.
Figure 1: Worldwide ETF growth
Source Morgan Stanley and Bloomberg
Figure 2: US-listed ETF asset growth
Source: Morgan Stanley research and Bloomberg
Figure 3: European-listed ETF growth
Source: Morgan Stanley Research, Bloomberg and SsgA
Figure 4: Japanese-listed ETF asset growth
Source: Morgan Stanley Research and Bloomberg