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© 2010, Morningstar, Inc. All rights reserved.
ETFs: Past, Present, and Future
Bradley KayAssociate Director, European ETF Research
Ben JohnsonETF Strategist, European ETF Research
March 25th, 2010
2
Overview
× A Very Brief History
× The ETF Marketplace Today
× What Is An ETF?
× What Advantages Do ETFs Offer?
× Trends For The Future
3
Whence We Came: ETF Market Evolution
4
A Very Brief History× 1990 – The SEC issued the Investment Company Act Release No. 17809.
This would ultimately facilitate the creation of mutual funds that were able to create and redeem shares intraday.
× 1993 – SPDRs S&P 500 begins trading on the AMEX in January.
× 1999 – The Tracker Fund of Hong Kong (TraHK) was launched in November, becoming the first ETF in Asia.
× 2000 – In April, the European Exchange Traded Fund Company launched a pair of listed diversified return securities (LDRS) on the Deutsche Borse. The funds, which tracked the EURO STOXX 50 and STOXX 50 indices were co-managed by Merrill Lynch. Later in the same month, iShares launched the first ETF in the UK, the iFTSE 100.
× 2003 – In February the first ETF on a fixed-income index in Europe was launched. The ETF eb.rexx Government Germany was issued by Indexchange and tracked the Eurex Bonds Government Germany index (eb.rexx).
× 2003 – ETF Securities launches the world’s first exchange-traded commodity Gold Bullion Securities in Australia and London.
5
European ETF Asset Growth by Broad Asset Category
Source: Blackrock, Bloomberg
£0
£25
£50
£75
£100
£125
£150
£175
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 J an-10
ETF As
sets
(GBP
Billion
)
Equity Assets Fixed Income Assets Commodity Assets
6
Where We Are Now
7
Category/Asset Class # of ETFs Total Net Assets As a % of Total Industry Assets
Europe Equity 424 60,526,666,986 42.47
International Equity 243 32,723,777,179 22.96
Fixed Income 153 30,582,153,845 21.46
Traditional Asset Classes 820
£123,832,598,010 84.68
Commodity 291 16,982,675,211 11.92
Other 18 1,476,473,085 1.04
Currency 22 208,379,461 0.15
European ETF Industry Total 1151
£142,500,125,766 100.00
Morningstar Data as of Feb. 2010
Proliferation of Asset Classes
8
Proliferation of Asset Classes
× In the beginning, ETFs only offered broad index and equity sector exposure
×Now, ETFs offer access to nearly every asset category imaginable
×Fixed Income×Fundamental Indexes×Commodities×Currencies×Leveraged Equity×Hedge Fund Strategies×Niche Sector Slicing
9
What Is An ETF?×An umbrella term, covering a broad array of legal
structures with a proliferation of abbreviations× ETFs× ETCs
×Defining attributes× Tracks a specific index or a strictly-defined
portfolio of securities×Almost exclusively passive investments
× Traded on a stock exchange×A retail investment vehicle by nature
× Short-term arbitrage opportunity via daily or weekly share creations/redemptions
× ETNs× ETPs
10
What Is An ETF?
×Typically UCITS III compliant× Diversified portfolios of securities: stocks,
bonds, derivatives
×Physical-replication ETFs× Match their index by holding the actual
securities in a unique trust× Full or Sampled replication
×Synthetic-replication (or swap-based) ETFs× Obtain their index exposure through OTC
swap contracts× Hold securities in their own trust and/or have
collateral pledged to mitigate counterparty risk
11
What Is An ETC?
×Formerly “Exchange-Traded Commodity”, now also currency funds
×Typically does not meet diversification standards for UCITS III
× Single commodity funds× Single currency funds
×Debt instruments issued by Special Purpose Vehicles (SPVs)
× Degree of counterparty risk varies widely
×European Union Prospectus Directive allows broad distribution
12
What Is An ETC?
×Physically-backed× Only precious metals× Virtually zero counterparty risk
×Synthetic-replication× SPV sometimes keeps the ETC’s capital, but
usually given to total return swap (TRS) counterparty
× Collateral may be allocated through a third-party custodian or simply pledged by the TRS counterparty
× Acceptable securities for collateral can vary widely from provider to provider
× Read Those Prospectuses!
13
What Is An ETN?
×Exchange-Traded Note
×Debt instrument issued by a backing bank× Senior, unsecured debt of that bank× Substantial counterparty risk!
×Not a very popular vehicle in Europe, with only two issuers
× Lyxor pledges collateral for their ETNs× Barclays Capital issues uncollateralized ETNs
×Much more popular in the U.S., where they have substantial tax advantages for futures-dependent indices such as commodities
14
Innovation, You Say?
15
What’s So Great About ETFs?
× Incredibly low costs
× Intra-day liquidity and real-time trading
×Access to new asset classes and strategies
ETFs bring the institutional to the individual
16
Low Costs
×Passive investments× No expensive analysts× Typically low turnover
×Numerous back-office and mid-office efficiencies for providers
× Only need to issue and redeem shares with a limited number of market makers
× Shifts portfolio trading costs to ultra-efficient market makers or swap counterparties
×Custodial costs have economies of scale due to cross-listings and broad distribution pulling in assets from across Europe
17
Intra-Day Liquidity and Real-Time Trading
×Real-time execution means that you know the price you are paying
×Can provide more liquid exposure to illiquid asset classes
× When corporate bond markets froze in 2008/2009, credit bond ETFs kept trading
×Market makers arbitrage away premiums and discounts, keeping prices close to fair value
×Warning: This shifts the onus of ensuring fair execution onto the final buyer rather than the provider
× Liquidity differs from fund to fund
18
Access to New Asset Classes & Strategies
×Funds for in-house use with sophisticated clients are now easily offered to retail investors as well
× Physical precious metals× Asset allocation strategies× “Alternative betas”
×ETFs serve as a wrapper for futures contracts that would otherwise have too high of a minimum size for retail investors
19
Where Do We Go From Here
20
Expansion of the Retail Market
×Everyone in the industry is waiting for the retail market to appear, but it will be harder than expected
×Four major preconditions to a robust retail ETF market in Europe
× Increased retail investor demand× Greater trading volume / visible liquidity× Greater transparency× Simple cross-border transactions within EU
21
Expansion of the Retail Market: Investor Demand
×Need to make the case to individual investors for low cost and passive investment
× Who will be the UK’s Jack Bogle?
×A critical mass of advisers and other financial professionals looking for low cost vehicles
× Organic movement toward fee-based financial advice took decades in the US
× Regulatory pushes in Europe may accelerate the process(UK’s Retail Distribution Review)
22
Expansion of the Retail Market: Greater Trading Volume
×OTC trading volume does not do much for retail investors
×Need to recruit a new sort of institutional investor, as heavy exchange traders and retail investors have a natural symbiosis in ETFs
× Make shorting ETFs easier× Movement toward ETFs as cheaper, easier,
and more flexible than other forms of beta exposure (futures, swaps, etc.)
×Moving trade volume onto the exchanges is a self-perpetuating process once it starts, as greater liquidity makes larger on-exchange trades easier, which in turn generates more liquidity
23
Expansion of the Retail Market: Greater Transparency
×Apply MiFID to exchange-traded funds× Reveal all liquidity to all market participants× Help retail investors feel comfortable that the
playing field is level
×Retail investors want to know what they are holding
× Full portfolios published frequently and with little delay
×Synthetic replication ETF providers will have to win not just on cost and on tracking, but also have to match the openness
× Make collateral rules easier to find× Disclose collateral portfolios as well as index
portfolios× This information is already available to
institutional investors
24
Expansion of the Retail Market: Cross-Border Transactions
×Liquidity makes ETFs a winner-takes-all competition
× Institutions will trade across borders for the best execution
× Retail investors need to be able to do the same
× This trend is already coming to fruition, as several retail brokerages offer fairly inexpensive trading throughout the EU
25
Consolidation in the European ETF Marketplace
×This winner-takes-all competition for liquidity will drive consolidation in the ETF marketplace
× One or two “winners” will take the vast bulk of assets and trading volume for any given index to track
× Despite having lower assets and not much growth, many smaller funds will remain alive on assets from in-house customers
×Off-exchange distribution channels can not drive this consolidation
× Liquidity and low trading costs are the draw of the top funds, and they do not carry over to off-exchange distribution
26
Product Innovation Will Continue
×New entrants in a more mature market can only compete on low costs or product innovation
×Plenty of new areas ripe for expansion× Fundamentally-weighted indices× Screened indices× Active ETFs× Funds of hedge funds× “Alternative beta”
27
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