Description
Exchange-traded funds (ETFs) are baskets of securities designed for trading and investment, which are listed on a major stock exchange. As of January 2002, roughly 120 ETFs existed in the USA market, equal in number to those elsewhere in the world. To date, virtually all ETFs are passively managed equity baskets based on market indices or averages; both bond-based, leveraged, and actively-managed equity vehicles are under development, subject to regulatory approval. A key structural feature of ETFs is that they can be redeemed and created in kind in institutional-size units; this results in the baskets' trading very close to underlying asset value -- making them perceived as much less uncertainty-prone than unit trusts or closed-end funds. A more detailed description of the mechanics of ETFs is provided on the website www.LipperWeb.com.
Attractions versus conventional fund vehicles
ETFs share a number of characteristics with conventional mutual funds. In some other respects, however, the ETF is superior. ETFs provide the central characteristic sought by index-oriented investors: they deliver the 'market' return on the designated asset class (minus very minor expenses) -- the investor trades away any chance to beat the market for the assurance of not failing to match it. Both vehicles provide expense ratios considerably lower than those for actively managed funds; both are regarded as quite tax-efficient.
Comparative advantages of ETFs also begin with low expenses, in that they almost always incur lower costs than do conventional index fund vehicles. The heavily-traded USA vehicle tracking the S&P 500 index, SPY, charges 9 basis points per year, roughly half the ratio of the widely heralded Vanguard Index 500, famed for its low costs to investors and generally seen as the standard setter among conventional index vehicles. ETFs' expense ratios in the USA population range from 9 BPs to 99 BPs/year, with those based on major domestic indices clustering at 25 BPs or lower and the international vehicles generally at 80 BPs or more -- still considerably below costs for comparable-objective, actively managed equity funds.
ETFs potentially possess a higher likelihood of tax efficiency than do conventional index funds, because they provide in-kind redemptions (portfolio securities, rather than cash) when institutional holders present shares for reverse creation. Typically the lower-cost shares held by the ETF are disgorged, along with attendant tax liabilities, in such events.
ETFs can be attractive for use by institutional investors even if used in sizes smaller than creation units. Index funds that may not have prospectus permission to use options or futures can readily buy small lots of an ETF corresponding to their index in order to remain fully invested rather than having cash drag. Likewise, if an index fund has prospectus permission to sell short or go short against the box, it could short small amounts of a matched ETF in the retail trading market for a tiny, single commission rather than undertake small sales of its entire component list. ETFs are also handy for managers wishing to use short sales.
The following points focus mainly on ETFs as viewed by the individual investor. Particularly below the largest tier of professionally traded funds, retail participation is crucial to promoting liquid markets.
ETFs are traded throughout the exchanges' session rather than being bought and redeemed only once daily after the markets' close and at unpredictable prices. Investors and traders can use a full range of order types, including market, limit, stop-limit, stop, short, and good-til-cancelled orders.
Current true-value information regarding the underlying portfolios of ETFs is superior to that for conventional index funds -- or for closed-end funds. ETFs' underlying portfolio values are calculated and displayed on quotation systems at 15-second intervals throughout the trading day. The valuation term used is not the Net Asset Value, but instead an Indicative Optimised Portfolio Value (IOPV). These are available via quotation symbols that differ from those of the stock prices of the ETFs. Studies have shown that major ETFs track IOPV very tightly; thinly traded vehicles, like any small stock, are less reliably fluid.
ETFs can be traded through any brokerage firm on margin; few brokerage firms allow use of mutual fund shares as loan collateral. For speculation, hedging, and tax-management purposes, ETF shares can be sold short.
ETFs can provide smaller investors/traders with a moderate (monetary) cost saving as compared with holding small positions in certain conventional index funds that charge small-account maintenance fees.
Regardless of where traded throughout the world, ETFs allow non-local persons (who are ineligible to purchase conventional mutual funds not offering a legal prospectus in their own nations) easy access to the major national stock markets. Where locally registered mutual funds offer limited variety, this is a major ETF advantage.
ETFs pose a small entry/exit disadvantage versus no-load funds: costs of entry and exit. ETFs are traded on a stock exchange so their purchase and sale generates payment of brokerage commissions. Commissions vary considerably among nations, although the recent trend has been toward unfrozen and thus declining rates.
Growth history and outlook
ETFs' assets grew rapidly from the late 1990s into the middle of 2000, when a bear market reduced valuations. Nevertheless, in the USA market ETFs now represent significant relative size as against conventional index funds -- and have grown faster than the latter funds historically did early against all equity funds. We believe that future growth of ETFs will not be exponential as some have projected but will be at a low positive rate. Some specific types of existing vehicle are likely to be more sharply impacted than are others. Potential for further ETF growth, and corresponding competitive impact, depends critically on regulatory developments in three areas: bond-based indices, leveraged portfolios, and especially ETF classes of actively managed funds. While most media coverage of ETFs has been rosy, we have concerns about what could go wrong, particularly if overproliferation of similar vehicles harms liquidity of many.
ETFs in the USA
The next discussion centres on the USA experience, primarily because the Lipper database is richest in that area and also since ETF market development in many other nations remains more limited to date. Experience and trends in early-developing theatres are likely to be useful as generalised guides in forecasting developments elsewhere over time.
The first USA ETF issued was the 'Spiders' S&P 500-based index basket, in January 1993. Since then over 120 have come to market. While there were some overlaps in the phases, in general the evolution of ETF types proceeded in this order:
Stages in the development of ETFs
| Type | First in |
|---|---|
| major domestic indices/averages | 1993 |
| non-domestic single-country indices | 1996 |
| domestic sector vehicles | 1998 |
| style vehicles | 1999 |
| competitive duplication | 2000 |
The largest and most actively traded issues by far are the QQQ for the NASDAQ 100 and the SPY for the S&P 500 index. Total value of ETF issues topped USD100bn briefly but was reduced to USD87bn at year end 2001 due to market declines. Two leading websites for tracking existing issues are www.nasdaq.com and www.iShares.com.
Worldwide growth and development outside the USA
While the 121 ETFs being traded in the USA (principally on the American Stock Exchange) were (at the time of writing) slightly more than half the world total, ETFs themselves are far from a solely American phenomenon. Growth in other nations seems to remain more rapid. A report by Merrill Lynch's New York-based Index Products group listed some 77 ETFs trading on 14 exchanges in 13 other nations, as of October 2001. By early February 2002, Lipper's research and sources had discovered 118. These, in order of number of listings, by country, were:
Number of non-USA ETFs by exchange
| Amsterdam | 29 |
| Paris | 22 |
| Deutsche B?rse | 18 |
| Toronto | 14 |
| London | 11 |
| Swiss Exchange | 10 |
| Japan | 8 (Tokyo 6 and Osaka 2) |
| Australia | 2 |
| Hong Kong | 1 |
| Johannesburg | 1 |
| Stockholm | 1 |
| Swiss Exchange | 1 |
| Tel Aviv | 1 |
This tally does include 23 issues dually listed on the Euronext market and, in a few cases centering on major multinational indices, some duplicated listings. We would expect that the total of non-USA listed issues will readily grow to more than half the world tally. But a sheer rise in numbers of ETFs available is not necessarily a positive development if growth duplicative vehicles are competing for trading and thus reduce each others' liquidity.
Annual expense ratios of ETFs traded on the exchanges noted above range from 0.08% and 0.10% at the lowest, to a high of 1.00%. A large majority cluster in the 0.25-0.50% range. This pattern is very similar to that seen in US-listed vehicles.
Not surprisingly, many of the ETFs trading alone on the local exchanges named above focus on a major index for that nation itself. All 13 of the Toronto-listed ETFs focus on Canadian securities. Euronext, which has discussed plans for 24-hour trading, focuses almost entirely on pan-European indices, and over half of its ETF vehicles (14 of 23) are iShares-branded and based on various MSCI Europe sub-indices. Germany's Deutsche B?rse carries 11 Dow Jones vehicles. These are mainly Europe-wide industry or sector baskets. However, it also includes the Dow Jones Global Titans 50, which is likewise traded in the USA. There are a few instances of two exchanges (Deutsche B?rse and Euronext for Euro STOXX 50) trading the same product, or parallel vehicles (e.g. TOPIX index) created by competing sponsors -- a pattern recently exhibited in the US market as well. Relatively few indices for US stocks are listed in these world markets: Toronto carries the iUnits S&P 500 index RSP Fund (sponsored by Barclays Global), while the Deutsche B?rse lists both the Dow Jones Industrial Average and the DJ Global Titans, managed by IndexCharge AG. No doubt the international availability of electronic trading means that physical locus of listing is of relative unimportance -- especially if extended trading days are available somewhere on the globe.
Nations now trading ETFs can benefit by comparing experiences, although ultimately local regulatory philosophies may govern final decisions. In two instances the US regulatory model has moved less quickly than those elsewhere. In Toronto, ETFs are being traded for Government of Canada 5- and 10-year bond funds. While these appear to be single-bond 'baskets' rather than more complex portfolios and are from the highest-grade national issuer, bond-based ETFs per se have yet to gain US SEC approval. And in Germany, two actively-managed mutual funds have reportedly been approved for ETF trading. The disclosure regime there, however, seems unlikely to be adopted in the USA: institutional investors apparently receive same-day disclosure of portfolio changes while the public waits for a day more. In any event, the logistics appear to have been worked out in order for such trading to occur.
We believe it is very important that duplicated trading in identical or virtually-same vehicles be rationalised in each national trading market so that liquidity is at the maximum possible level. That will ensure good execution and thereby project a positive rather than a troubled image of ETFs to the media and potential investor/traders, both individual and institutional.
ETFs as competition for conventional index mutual funds
The development history of ETFs must be examined against that of the fund types they most closely resemble, and with which they compete. One can make the case that indexing was a major innovation against active management; ETFs represent a refinement of indexing in which other convenience factors have been added. Thus the following USA data may summarise key points.
First appearance and current total assets ofconventional index funds by major type
| Value at year end 2001 (USD) | ||||
|---|---|---|---|---|
| First appearance | Index | Total | Percent | |
| S&P 500 | 1983 | 209.29 | 209.20 | 100.0 |
| Other equity | 1968 | 120.23 | 3102.71 | 3.9 |
| Bond (non-MMF) | 1986 | 34.88 | 863.10 | 4.0 |
| Total: bond & equity | -- | 364.40 | 4175.01 | 8.7 |
It is nine years since EFTs first appeared in the USA market. At USD87bn they are 26.4% of the conventional (equity fund) assets against which they now compete. That is a considerably larger and more rapid penetration than indexed funds have achieved within the overall USA funds battleground -- some 8.7% after nineteen years. What is notable is that the adoption of index funds has been quite small in areas other than S&P 500 vehicles, as shown in the table above. As a reference point, the two existing S&P 500 ETFs traded in the USA marketplace total USD31.6bn, or about 15.5% of S&P 500 indexed assets in conventional funds. The remainder of USA ETF assets -- USD50.9bn -- is over 42% the size of non-S&P-500 index-fund assets, an impressive accomplishment in just a few years. Whether this reflects a preference for lower expenses or primarily the other major benefits of ETFs is not clear. We find it of interest that indexed bond funds have captured a relatively small portion of overall indexed assets, as compared with the bond share of conventional funds:
Percentage of assets in funds
| Index funds | Non-index funds | |
|---|---|---|
| S&P 500 | 57.4 | 5.0 |
| Other equity | 33.0 | 74.3 |
| Bond (non-MMF) | 9.6 | 20.7 |
| Total: bond & equity | 100 | 100 |
Since creation of the ETF vehicles can be accomplished only by qualified institutional investors, one might surmise that many of the assets in the SPY represent diversion from what would otherwise have been invested in conventional S&P 500 index-fund vehicles. Individual investors have made net open-market purchases of the SPY and the iShares vehicle (ticker IVV) from creating institutions, but the degree of relative ownership cannot be readily ascertained, changing daily due to short-term speculative interest. Clearly, ETF S&P 500 products (principally the SPY) have displaced what would have been further growth in conventional institutional S&P 500 index-fund assets since the early-middle 1990s. Individual investors' purchases of SPY and IVV in the aftermarket likewise (at least for the the longer-term oriented portion) would otherwise have gone to conventional index funds if ETFs had not become available. The amount, of course cannot be readily computed.
By logical extension, we surmise that non-S&P-500-based ETFs have also captured some monies that would have gone into conventional index-based funds if ETFs were not available. Data are not obtainable which would allow separation of long-term holders' assets in such ETFs from those of traders. Longer-term holders are most clearly net losses in market-share terms for conventional index products; recently escalating moves by conventional funds of all kinds to penalise and charge added fees to shorter-term holders for rapid or frequent sales are also driving some such participants to ETF alternatives. It seems quite possible that the shorter-term, 'hot' money in ETFs has been diverted from conventional funds in part to escape their rising restrictiveness, in part to utilise intraday execution, and probably also represents some substitution for purchases of individual stocks.
Impacts on and interactions with closed-end funds
Unlike open-end mutual funds, not all closed-end funds (known as 'investment trusts' in the UK) publish their NAVs daily. The 80% that do so in the US closed-end funds (CEFs) arena provide helpful information. But even once-daily values are of marginal guidance when compared with frequent intraday IOPVs supplied for ETFs. Furthermore, frequency of information is less crucial as an advantage for ETFs as against tracking accuracy of market prices. Thus, ETFs display some significant advantages when lined up against CEFs.
In late 2001, the 475 USA-listed CEFs ranged from a 65% premium to a 41% discount; median was a discount of 11%. Just three months later the median had wandered to 2.3%. Although this latest movement was favorable for holders, index-oriented investors prefer lack of premium/discount uncertainty. This is exactly why no index-based CEFs exist, at least in the USA market.
We see evidence that issuance of world-equity CEFs has been virtually stopped cold since country ETFs first appeared (1996). Some 100 world-equity CEFs were issued up to 1995 but a mere two have had IPOs since. In open-end world equity funds the totals for those periods were quite steady at 408 and then 415. We have also noted a high incidence of open-endings, mergers, and liquidations in CEFS, which seems probably related to ETFs' availability. While overall some 23% of single-country CEFs have disappeared, among CEFs directly matched against ETFs, some 42% have open-ended or merged or liquidated. One cannot prove causality in investment markets, but the figures are striking.
CEFs are unlikely to be swept to history's dust-bin by ETFs, however. Only asset types where numerous liquid securities are available are prime targets for ETF competition. Besides country-equity funds, sector portfolios are naturals; several ETFs have appeared in technology, health care, utilities, and real estate, in fact. Over 75% of USA CEFs are bond portfolios, and many represent municipal securities of single states. We believe only New York and California might be suitable ETF targets in terms of sufficient trading interest to create liquid pricing. And of course many bond CEFs utilise leverage. US regulators have not yet permitted either bond-based ETFs or leveraged-portfolio ETFs -- and we wonder whether investors even wish to actively trade yet another bond-based vehicle.
Where straight-up competition exists, ETFs have gained the upper hand in trading. Matching 10 single-nation CEFs and ETFs, we noted a 234% rise in value of share trading from 1997 to 2000; the ten ETFs collectively trade 2.5 times as much; eight of the ten out-trade their CEFs counterparts. We believe that tracking versus discount risk is the ETFs' major advantage.
Future challenges and opportunities for ETFs
We believe that in the relatively far advanced USA ETFs arena, the phase of rapid asset growth has passed. Crucially, virtually all conceivable equity index baskets of interest have already been addressed. Over the longer term, assuming equity prices rise, some increase in assets will flow from valuation. But major asset increments otherwise require net new creation by qualified institutional investors. As discussed elsewhere, two of the main unresolved regulatory issues now blocking a major potential increase in ETF assets are pending decisions on bond-based portfolios and creation of actively-managed funds ETFs. While not all funds would be useful or willing as bases for ETFs, some larger ones clearly might be, assuming approval and the resolution of logistics issues on value dissemination. We have considerable doubt regarding what interest institutions may display in bond-based ETFs, and therefore we presently do not see significant growth of assets in that area. We base our caution on the relatively small number of indexed bond funds in existence and on the availability of extremely deep trading markets in government bonds and derivatives -- raising the serious issue of whether new vehicles are needed.
Another ETF type now at the regulatory-application stage is the leveraged index fund. These already exist in the USA market as open-ends, where principal providers are ProFunds and Rydex. In the open-end funds arena, such vehicles typically provide 150% or 200% of the volatility of underlying major indices. They have proved popular with short-term traders since the sponsors do not restrict frequent entry and exit. Presumably trading would be brisk. The degree of interest by large institutions is yet to be proven. One major issue that may handicap US approval of leveraged-index ETFs is that its regulatory body, the SEC, apparently considers them to be a sub-set of the actively-managed funds world, with the result that their possible approval will be tied to that arena as well as to the direct merits of the leveraged portfolios per se.
Our major concerns about ETF market development also lie mainly in the realm of potential unfortunate future events -- driven mainly by possible liquidity problems. A crucial positive feature of ETFs is their intended and structurally supported likelihood of trading at very close to underlying IOPVs -- else they will be perceived as premium/discount-uncertain cousins of CEFs. The following are possible downside scenarios of concern to us:
- In a given ETF, the last long-side creation-unit holder among institutional investors wishes to close out its position. What happens to retail investors who hold, variously, long and short positions? Would the ETF remain efficiently priced? Would liquidation, with its potentially undesired tax consequences, by forced on remaining holders? Could retail shorts be squeezed brutally?
- Even if the last institutional block remains in place, could relative lack of interest in the asset class or the specific basket create an absence of institutions ready and willing to execute price-disciplining swaps, proving false the efficient-tracking assumption retail holders are using?
- In an extreme market-meltdown scenario, might no institutions be willing to risk capital on the long side to assemble creation units and thus support market prices, as expected, at true underlying value?
- If a nation for which or in which an ETF trades should suddenly impose capital controls, might the creation/de-creation mechanism be disabled for a short or extended period -- again defeating expected tracking?
- Could the sharp price appreciation of an individual stock in a short-list ETF force sale under the 25% SEC concentration rule, creating a surprisingly distasteful capital gains event? (This occurred with iShares Sweden when a major technology company's price skyrocketed. Recent changes in composition of the MSCI indices to reflect truly floating shares are a positive but practically limited response in this area.) But unacceptable concentration could occur in cases of large corporate takeovers for cash, or purchases by acquirors outside the field of permitted content.
- Creation of multiple house brands of ETFs covering the same or highly similar asset baskets can lead to sparse trading in all or nearly all of them, such that retail orders are executed at unfavorable prices. Bad media publicity, investor word-of-mouth, and possible legal filings would quickly cast a dark cloud over all but the few most heavily traded ETFs -- presenting a self-sustaining problem.
We are especially concerned about the last point. It is possible that corporate ego, combined with the desire to create a full product line, could lead to stubborn over-creation of redundant ETF baskets in some asset classes. Already in the USA market space we see clusters of at least three ETFs each for Health/Biotechnology, Energy, Financial Services, the Internet, MidCaps, Real Estate, Technology, and Utilities. Are these multiple vehicles truly necessary when, so far, only two S&P500-based ETFs -- a hugely more popular asset class -- have come to market? Hard data show with brilliant clarity that trading activity is overwhelmingly focused in the first-to-market ETF of any type.
Liquidity and price continuity are very important to the sustained favourable reputation of ETFs. It is now generally forgotten, but in 1996 just one week after the Morgan Stanley-sponsored WEBS came to market, the smaller and unrelated firm Morgan Grenfell (now of Deutsche Bank) introduced nine single-country ETFs of its own, trade-named Country Baskets, listed on the New York Stock Exchange. Seven competed directly with WEBS. Country Baskets failed to capture significant trading volume, which raised issues of potential failure to track their underlying values closely. The most active basket, for Japan, traded only about 8,000 shares per session, or 10.5% as many shares as the WEBS vehicle for the same nation. With roughly 30 days' notice, all nine of the Country Baskets were liquidated as of year end 1996 -- less than ten months after launch. Their failure to catch on was a lesson for those inclined to heed it: competing vehicles representing the same underlying asset class of index are likely to be less successful than single vehicles, since liquidity is a major criterion for investors' willingness to participate.
We believe that the single regulatory decision potentially most favourable in impact on total net asset growth by ETFs would be permission for ETF classes of popular actively managed equity funds. ETFs would undoubtedly derive the vast majority of their assets from (higher-fee!) existing assets in the mutual funds industry. Therefore the net effect on the advisor industry will be to lower average fee received per amount of assets under management. While this is negative, considerable positive implications for portfolio managers and for individual investors would exert positive pull in the direction of creating such vehicles. Shareholder churn in conventional fund classes could be greatly reduced by an effective campaign to move traders out to the available ETF classes. This would ease the burden on portfolio managers caused by untimely and frequent cash in- and outflows. Funds with lowered churn could reduce their frictional cash balances considerably from the present average levels of over 5%. That reduction in cash drag in turn would help funds to perform more in line with, or more easily beat, their benchmarks in bull phases. Reductions in portfolio turnover enabled by the sharp decrease in shareholder-money churn would in turn reduce the expected annual capital-gains distributions as a percentage of net asset value. This improvement could blunt the recent tide of strident media reports about tax inefficiency, and could re-attract to the mutual funds world (in both conventional and ETF classes) some money recently migrating toward individually managed accounts (where individualised tax considerations are an important decision factor).
ETFs of conventional funds could enhance asset retention by these funds. Expenses of ETFs are lower, so investor money would be attracted to such new opportunities in ETFs.
Assuming that in the USA regulatory approval is granted for trading in ETFs of actively managed portfolios, we believe the model will be similar to that contemplated by Vanguard for its now-cancelled plan to trade 'Viper'-class (ET) shares in five of its major index funds. Current shareholders in approved funds would presumably be given a one-time, calendar-limited option to exchange on a tax-free basis into an equal number of ETF-type shares of the funds involved. Exchange trading could then begin. Presumably institutions would be offered the chance to create or destroy ETF shares in the usual in-kind manner (this would be required for assuring tracking discipline). Some implications follow from this structural model:
- Only very large funds would be creating ETF classes (since liquid trading is required for efficient pricing and since institutions could redeem proportionally disturbingly large blocks if the fund were small).
- Fund families permitting ETF classes will experience some decline in fee income and profit margin due to a net shift to lower-fee classes.
- Funds involved would enjoy reduced churn of shareholder money, which would be helpful to the portfolio manager and would potentially reduce turnover and therefore tax inefficiency.
- Competing funds (by investment objective or style) might experience some departure of hot-money holders who would prefer the ETF attributes.
- The latter effect is likely to be muted or delayed in funds that have experienced severe net asset value declines since early 2000, since investors typically are loath to accept losses.
What is the possible impact of ETFs on what in the USA are called Unit Investment Trusts (UITs) -- unmanaged term trusts? The main attractions of UITs are their low costs, typically extremely low turnover (implying tax efficiency with regard to capital gains), and, in the case of bond trusts, targeting of a maturity date at which the portfolio should trade at face value. The major shortcoming of UITs is the small and little-publicised aftermarket. While most UIT buyers do not intend to depend on liquidity, unanticipated emergencies inevitably can arise during lengthy holding periods. The constant trading of an ETF would offer comparative advantage over the very thin aftermarket for UITs. However, that does not make the ETF necessary as an alternative: open-end mutual funds and some closed-end bond funds structured as term trusts also exist, both providing liquidity long before expected wind-up dates. And it is presently unknown whether the proposed bond-fund-based ETFs will actually attract an active following among traders, so as to ensure desired price continuity. UIT holders are typically inactive, whereas ETFs appeal to aggressive participants.
Implications by type of participant
Space does not permit recitation of the numerous interesting impacts that ETFs will have on various organisations and individuals. We see definable implications for regulatory bodies and stock exchanges; index owner/publishers; sponsors; advisor/managers of conventional index funds; non-index open-end fund managers; closed-end fund advisors and shareholders; broker-dealers; financial planners managing individual accounts; and individual investors. Our firm has prepared an extensive report on ETFs which includes that material. Interested parties may contact Lipper USA internationally at 303-534-3472 or domestically at 1-877-955-4773.
