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Exchange-traded funds - Twenty years young

2013-01-29 10:29:06

The anniversary of a successful financial innovation

Jan 26th 2013 |From the print edition

TWENTY years ago this month, State Street, an American financial-services

group, launched a listed product called an exchange-traded fund (ETF), which

tracked the S&P 500 share index. Because of its ticker code, SPDR, the product

soon became known as the Spider. It was not the first quoted fund to track an

index (that was launched in Toronto in 1990) but the Spider fund quickly became

the template for an industry that now controls around $2 trillion of assets,

almost as much as the hedge-fund sector.

The ETF is one of the more successful financial innovations in recent decades.

Its success has been driven by two things: cheapness and convenience. The total

expense ratio (a fund s expenses divided by its assets under management) on the

Spider is just 0.09% a year, allowing investors to get a return that is close

to that of the overall stockmarket. Compare that with actively managed mutual

funds, which try to pick stocks and have expense ratios of over 1% a year. On

average actively managed funds are unlikely to beat the index; some

underperform by a big margin.

Secondly, the industry has expanded so rapidly there were 4,731 funds at the

end of last year that investors can use ETFs to invest in almost any asset

class (see chart). It is possible to create a fully diversified portfolio

consisting entirely of ETFs and to switch the allocation of that portfolio

within seconds. That has made the funds highly attractive to high-frequency

traders and to hedge funds: some 16% of trading volume at the New York Stock

Exchange in 2012 was in ETFs.

There seems to be no sign of a slowdown in the industry s growth. Investors

piled a further $265 billion into ETFs in 2012, up from an inflow of $170

billion in 2011. The compound annual growth rate of assets over the past decade

has been 29.6%, according to ETFGI, an information provider. Even at $2

trillion, the industry is still a tiddler compared with the $26 trillion

invested in mutual funds worldwide.

Index-tracking is one area of fund management where it is possible to achieve

economies of scale: it costs little more to manage $10 billion than $1 billion.

Fund managers can benefit from a virtuous circle in which bigger funds mean

lower fees, attracting more investors and leading to even bigger funds. As a

result the industry is highly concentrated. The three top providers, iShares

(part of BlackRock), State Street (which uses the Spider brand for all its

funds) and Vanguard, control almost 70% of assets. BlackRock this month agreed

to buy Credit Suisse s ETF business, with $17.6 billion of assets in 58 funds.

The industry s rise has not been without controversy. Early ETFs like the

Spider resembled the index-tracking funds that had been created in the 1970s:

they mimicked a benchmark by buying all the constituent stocks or bonds. But as

the industry branched out into other, less liquid types of assets, it proved

far more difficult physically to buy all the index components. Some ETF

providers gave exposure to such asset classes in the form of a swap agreement

with a counterparty, normally a bank, which agrees to match the return achieved

by the benchmark index.

The appearance of these types of products, usually described as synthetic ETFs,

caused some alarm among regulators. In March 2010 the Securities and Exchange

Commission suspended the approval of new synthetic ETFs (existing products were

allowed to continue). A trio of international watchdogs the Financial Stability

Board, the Bank for International Settlements and the International Monetary

Fund all worried aloud.

In particular, the authorities fretted about the links between investment banks

and synthetic ETFs. What if the bank counterparty to a swap went bust, a

natural concern in the wake of the collapse of Lehman Brothers? The issue was

most pertinent in Europe, where synthetic ETFs were more widespread than in

America.

Although there has been no regulatory restriction on synthetic ETFs in the EU,

investors seem to have voted with their wallets, favouring the providers of

physically backed funds. In 2012 iShares (which mainly offers physically backed

funds) increased its European market share to 38%; the db X-trackers and Lyxor

brands, which both rely on synthetic funds, lost ground. But there are some

asset classes notably commodities where it makes more sense to use derivatives

or swaps than to buy the assets outright; fund managers cannot store corn or

pork bellies. So synthetic ETFs will not disappear altogether.

Another regulatory worry concerns the existence of leveraged ETFs, which aim to

give investors a geared exposure to an asset class. Because of the way they are

constructed, the returns from leveraged ETFs do not, over the long term, tend

to deliver returns that closely track the chosen benchmark, creating the

potential for small investors to be misled.

So far, however, the industry has not seen the kind of scandal that might

tarnish its image. And innovation continues apace. In December iShares launched

a range of minimum-volatility ETFs in London, which are designed to give

investors exposure to the equity market with less risk, by choosing stocks that

have been more stable than the overall market. If you can dream up an

investment style, the industry will create an ETF to match.