Since they were first created in 1990, exchange-traded funds (ETFs) have opened up a whole new universe of assets for investors, such as emerging markets and commodities. There is no wonder for the tremendous success that ETFs have encountered among institutional and retail investors over the past decade: ETFs are low-cost, easy-to-trade investments, and one can choose from a huge diversity of them. ETFs were born as tools for indexing, but because of their many advantages they can now be used in a wide range of strategies which often would be very difficult with traditional mutual funds.
Background
The first ETF was introduced on the Toronto Stock Exchange in 1990, but it is with the launch of the first ETF on the American Stock Exchange in 1993 that ETFs started gaining popularity: the SPDR (pronounced ‘spider’, standing for Standard & Poor’s Depository Receipt) was designed to track the return of the S&P 500 Index – by holding all the stocks in the index within a pooled fund structure – in a single tradable share. The first sector ETFs were introduced in 1998; designed to track the sectors of the S&P 500 Index they have many applications, including sector allocation/rotation strategies.
As the chart below illustrates, it was around that time that both the number and assets of ETFs took off. Today, more than half a trillion dollars are invested in about 800 ETFs around the world, and these figures are still growing exponentially: the number of ETFs increased by nearly 50% in 2006 alone. The US market is by far the largest market for ETFs with over 70% of global assets, but the success of ETFs in Europe has been no less spectacular with assets increasing by over 60% to nearly USD90bn in 2006.
Figure 1: Worldwide ETF growth
The tremendous success of ETFs over the last decade is testimony to the fact that institutional and individual investors feel increasingly comfortable using these vehicles, recognising them as a valuable addition to securities markets. ETFs today are widely used by investment professionals, pension funds, hedge fund managers, arbitrageurs, traders, market makers, financial planners and individual investors alike. Several ETFs now even rank among the most actively traded stocks in the US.
Rationale for ETFs
ETFs are special open-end funds that track an index and trade on stock exchanges like ordinary shares. ETFs were established to provide investors with the benefits of indexing, while shielding them from the higher costs associated with traditional funds. The rationale behind index investing stems from the theory that it is very hard for active managers to beat the market, therefore if you can’t beat it, join it!
An important factor for the tremendous success of ETFs is that they offer several significant advantages over traditional funds:
- ETFs are flexible. ETFs provide immediate diversification, they are very liquid and easy to trade. Since ETFs are listed and traded on exchanges like ordinary shares, investors don’t encounter many of the trading restrictions that traditional mutual funds often impose, such as minimum holding periods and entry/exit penalties. ETFs can be bought and sold any time during the trading day – not just at the settlement price at the end of the day like most mutual funds. Investors can use stop-loss orders to help protect capital and ETFs can also be shorted and margined.
- ETFs are transparent. Portfolio holdings and performance are always transparent since they are pre-determined by the index-linked structure. By contrast, traditional, actively-managed mutual funds publish their holdings less frequently, such as quarterly or semi-annually, but are buying and selling every day – therefore investors never know exactly what they are buying.
- ETFs are cheap. ETFs have a lower cost structure than mutual funds and are tax-efficient due to low portfolio turnover.
Unlocking new asset classes
While the first ETFs were linked to broad-based equity indices, the past few years have witnessed the expansion of ETFs into various regions and asset classes that were not so readily accessible in the past, such as emerging markets, real estate, currencies and commodities. The demand for products providing exposure to more asset classes – such as private equity funds and hedge funds – is driving new ETF launches today. With the number of potential investments increasing, the investor can maximise the opportunities for diversification, hedging, or targeting higher returns.
Emerging markets are an obvious example where investors have benefited greatly from the development of ETFs. There is some evidence that the benefits of international equity diversification have become less pronounced with globalisation as markets have deregulated and developed economies become increasingly integrated. As a result, the prospect of lower correlations – together with the positive returns that emerging markets have experienced recently – has significantly raised the appeal of emerging markets as an asset class. Prior to the development of ETFs, the investor was confronted with very high barriers to equity investment in these regions:
- Access – Access to the local market may be restricted or not allowed at all. Some countries restrict the amount of stock that can be held by foreigners through ownership limits or by creating special share classes for locals or foreigners. Additionally, authorised investors are sometimes the only investors able to invest in local firms. Repatriation of invested capital is often restricted, especially in times of crisis, while discriminatory taxes can be applied to foreign investors.
- Costs – Higher transactions costs represent additional barriers to investment. These costs include commissions to foreign brokers and for foreign exchanges, wider bid-ask spreads, and potential price impact of trades due to lower liquidity. Liquidity in emerging markets is often quite low as a result of either small market capitalisation or government capital controls. Trading mechanisms can also be less reliable than in developed markets.
- Comfort – Unfamiliarity with international markets (e.g., culture, language, business practices, and information sources) may cause investors to limit foreign investment or to be wary of investing abroad.
These issues magnify as the number of foreign investments increases to ensure sufficient risk diversification; however, ETFs solve or reduce most of these problems. For all these reasons, ETFs on emerging markets have been extremely successful. The iShares MSCI Emerging Market ETF has grown to be the fifth largest ETF in the world, accumulating over USD15bn in assets in just 3½ years, highlighting that ETFs are a popular tool to gain exposure to markets that were previously hard to access.
Exchange Traded Commodities
Individual investors have long lacked low-cost, convenient tools for participating directly in commodities without dealing in complex derivatives markets. Mutual funds that invest in commodity companies such as mining and energy stocks have been around for some time, but they are not perfectly correlated with commodity returns, and some commodities are not even covered.
The first commodity tracker – Gold Bullion Securities – was listed in Australia in 2003 by the management of ETF Securities. Gold Bullion Securities track the spot price of gold by holding physical bars of gold in a secure vault and issuing one ETF for every 0.10oz deposited. Several ETFs have since been issued, tracking broad commodity indices or single commodities. Overall there are now about USD20bn of assets invested in commodities through ETFs and ETCs. In 2006, ETF Securities listed a whole commodities platform comprising 31 commodity trackers or Exchange Traded Commodities (ETCs) on the London stock exchange.
ETCs are very similar to ETFs, as they are listed transferable securities and they enable ordinary investors to buy and sell exposure to commodities through regular brokerage accounts, providing cheap and easy access to an asset class that has previously been difficult to access. Now ETCs allow investors to access niche commodity sectors such as agriculture, base metals and oil. Indeed, many see ETCs as a great alternative to futures: they can be purchased in smaller sizes, and don’t require special documentation, special accounts, rollover costs or margin. For the first time ever, investors are now able to trade all the world’s major commodities in a single time zone and on a single exchange. As a result, most major European stock exchanges have followed suit by launching their own local ETC platforms.
Figure 2: Worldwide ETC growth
The future of ETFs
The success of passive ETFs has paved the way for new products. The first structured ETFs were created in 2003 by PowerShares with the aim of tracking the returns of stocks with high growth potential. The methodology utilises sophisticated quantitative analysis to evaluate and select component securities using a wide range of investment value determinants. Since then, the number of indices which incorporate alternative weighting strategies has multiplied rapidly. These ETFs, which modify or aim to improve on traditional benchmarks, seek above-market returns. Meanwhile, other issuers have started to use derivative solutions to improve returns or to limit risks for investors. ETFs now include leveraged and inverse returns on an index – allowing investors to adopt strategies they could not previously replicate. Looking forward, there are now increasing opportunities for issuers to create more sophisticated products to provide more tailored strategies for investors in a simple and easy manner.
Conclusion
The ETF market has come a long way in the past decade. The extraordinary development and acceptance of ETFs around the world over such a short period of time can largely be attributed to the fact that ETFs have proven themselves to be well-designed, cheap and flexible tools that have tremendously expanded the universe of investable asset classes and investment strategies. Prior to ETFs, the average investor was generally limited to long-only strategies and the universe of domestic stocks, bonds, and less efficient mutual funds. Today there are ETFs tracking a range of investments including broad-based indices and specific sectors; developed and emerging markets; equities, bonds, real estate, commodities; investment styles and quantitative indices; leveraged and inverse ETFs. New ETFs will certainly continue to open up access to new and original asset classes, allowing investors to adopt more tailored strategies.
