The outlook for the capital markets and the economy may be clouded, but the climate for launching exchange traded funds looks bright and clear! In 2006, the ETF population exploded by 75 percent, reaching 357 funds, according to the Investment Company Institute (ICI). This year looks poised for more of the same. On one day in February alone, for example, ProShares Trust rolled out 22 new funds on the New York Stock Exchange--a new daily record for ETF productivity.
Impressive, but the game has only just begun. ETFs are said to be competition for mutual funds, and by that standard the ETF boom has legs. At the end of 2005, ETF assets in the U.S. totaled a mere 3 percent of the $8.9 trillion in mutual funds, the ICI reports. If ETFs are destined to grab money from mutual funds, the golden days of growth are still ahead.
There's just one small glitch. Each and every new ETF needs an index--these are index funds, after all. But after 14 years of minting product, there aren't a lot of widely recognized indices left that haven't already been securitized in an ETF. Yet if last year's pace holds steady for the next 10 years, more than 1,500 new ETFs will arrive between now and 2017. Keeping the IPO shoot greased, then, means that ETF providers must find 1,500 indices above and beyond the existing pool of names already in use.
How will the market cope? There are five basic solutions:
1. Invent new benchmarks.
2. Dig deeper into the remaining supply and tap the relatively obscure indices not already tethered to an ETF.
3. Tweak the old benchmarks, by offering levered or short exposure on familiar indices, for example.
4. Focus on asset classes with thin or nonexistent representation in ETFs.
5. Convince the SEC to approve actively managed ETFs.
The first four solutions are already popular. Meanwhile, the actively managed ETF remains a regulatory question mark for the moment, although the idea is reportedly close to receiving SEC approval.
In fact, all five solutions are likely to prevail over the long haul. The bottom line: ETFs in the future will look radically different from their predecessors. The days of rolling out new funds that track familiar indices with obvious appeal are drawing to a close. Increasingly, the ETF marketplace will be defined by innovation in indexing.
It's too soon to say if the trend represents progress--or something less--but this much is clear: The next wave of ETFs will introduce a new palette of opportunities and risks, much of it untested beyond paper trading. That's quite a contrast to the ETFs of the first decade or so which were characterized by well-known indices with widely understood risk/return profiles from the likes of S&P, Russell, MSCI and Dow Jones.
The learning curve has been relatively undemanding for ETFs until recently. The future promises to be more complicated. In fact, the future is already here. "If you look at last year, there were a lot of new ETF product introductions, and many of them have been based on new indices," observes Scott Ebner, senior vice president of the American Stock Exchange's ETF division.
That includes PowerShares' latest installment of so-called fundamentally weighted sector ETFs, which compliment earlier rollouts of broader minded equity ETFs cut from the same indexing-design philosophy. The underlying benchmarks are the brainchildren of Research Affiliates, which was founded in 2002 by Robert Arnott, a respected veteran of the investment management business. His current firm has been at the forefront of rethinking and reinventing market-cap-weighted equity benchmarks with an eye on enhancing returns and minimizing risks. Before teaming up with Arnott, PowerShares launched a suite of quasi-actively managed ETFs, rolling out its first product back in 2003. Its first fundamentally weighted ETF tracking a Research Affiliates' index arrived in December 2005.
Critics say that some of the firm's ETFs are not really index funds, even though they track benchmarks. The basis for the charge is that the underlying indices favor certain stocks as per a rules-based system for selecting companies designed to deliver superior results relative to a cap-weighted index. Arnott counters that there are better ways to index than the standard market-cap weighting system.
PowerShares' brand of ETFs may be controversial, but minting new ETFs that stray from conventional notions of indexing is a growth industry. Consider the Claymore/Ocean Tomo Patent, an ETF launched last fall that replicates an index focused on stocks deemed to own "valuable" patents. The same firm also recently launched The Claymore/Clear Spin-Off ETF, which hugs a benchmark comprised of companies that have been recently spun off, or separated, from corporate parents. And in early March, XShares Advisors launched nine narrowly focused healthcare ETFs, including the HealthShares Metabolic-Endocrine Disorders fund.
The point is that indices aren't always passive gauges. Benchmarks can be engineered to perform any number of quantitative feats, which may or may not reflect the unmanaged returns of an asset class. Many of the quantitative screening processes that are embraced by active managers can be repackaged as rules-based benchmarks, which in turn can be used as the basis for index funds. That's a plus for ETF providers searching for new ideas to fuel product growth.
Imagination, entrepreneurial spirit and vigorous marketing, in other words, are in high demand for keeping the ETF business humming. For instance, last year WisdomTree Investments began selling several funds tracking indices that weight stocks by earnings, or if you prefer, by dividends.
Love it or hate it, such ideas are gaining traction. WisdomTree has been creating ETFs for less than a year as of this past January, and already it had about $2 billion under management, according to Morningstar Principia. PowerShares, which started in 2003, had more than $9 billion in ETF assets by that time.
A byproduct of the rising tide of ETF launches is a lively market for thinking up new benchmarks. A sign of the times is the appearance of IndexIQ, a one-year-old Rye Brook, New York boutique firm that designs indices that "bridge the gap" between active and passive money management. So says Adam Patti, CEO of IndexIQ, which licenses its benchmarks to ETFs, separately managed accounts (SMAs), institutional funds, and anyone else looking for different spins on indexing.
One example of the IndexIQ mindset: Building indices that weight equities according to their innovation. How do you measure innovation? There are a variety of metrics, Patti says, including capital expenditures, the amount of spending on research and design, and new product developments. "Our Innovative Companies Index seeks to identify companies that, through strong reinvestment and commercializing their innovation, are consistently improving their financial results," he explains. Other indices focus on companies with relatively strong profits or companies said to harbor enduring competitive advantages.
As we go to press, 20 ETFs linked to IndexIQ indices are in registration, Patti reports. The ETFs will be managed by XShares Advisors in New York. But that just scratches the surface of IndexIQ's inventory--and ambitions. Patti tells Wealth Manager that the company has 20 families of metrics (innovation being only one), which represent about 200 indices.
The peculiarities of ETF regulations are driving the surge in index design. ETF managers are currently required to track indices that are crafted and maintained by separate entities. But no matter who invents the indices, in theory the sky's the limit. IndexIQ signaled as much with its recent launch of a family of "synthetic" hedge fund indices to round out its offerings.
As any quantitative analyst knows, there's no shortage of investment factors to slice and dice, and so the available supply of new indices is theoretically unlimited. Market capitalization may still be the dominant factor in terms of indexed assets under management, but ETF providers are challenging the status quo.
In short, prepare yourself for a wave of new ETFs tracking indices whose benefits, if any, aren't immediately obvious for long-term investment strategies. But for short-term, speculative-minded traders, the opportunities are endless. Perhaps there'll be an ETF tracking an index of companies posting the biggest earnings surprises. Or the biggest change in price volatility. Why not combine both factors?
The new world order of ETFs may reward creativity, but it threatens to tax investors as they attempt to separate the worthy from the foolish. In contrast, most informed investors understand what they're getting in funds replicating the S&P 500 or the Lehman Brothers 7-10 Year Treasury Index. As the ETF business moves into uncharted waters, the burden of due diligence will grow for those intent on sampling unexplored terrain.
Invariably, the marketing brochures for the new indices and their ETF offshoots cite the fabulous results of back-testing. Only those strategies that hit the back-test pay dirt are given the opportunity to graduate to ETFs. That would seem to weed out the great ideas from the bad ones. But investing isn't quite so simple. As any seasoned investor knows, a paper history doesn't insure success after a transplant into the real world where taxes, trading costs and other challenges apply.
Regardless, a much larger pool of ETFs is coming to your investment menu soon. There are thousands of mutual funds, notes Arnott, and there's no reason there can't be thousands of ETFs.
A fair amount of the increased demand for ETFs is coming from the investment profession, says Tim Meyer, ETF business manager at Rydex Investments, a firm that is no stranger to offering distinctive funds in both open-end and ETF formats.
But not every wealth manager sees the burst of ETF ingenuity as a positive. "As a lover of ETFs, I find it somewhat discomforting that we're seeing all these pet indices and some silly notions come into the ETF market," complains Russell Wild, a principal of Global Portfolios in Allentown, Pa. and author of Exchange-Traded Funds for Dummies.
Bill Bernstein of Efficient Frontier Advisors in Eastford, Conn. is also skeptical of the new crop of ETFs. "The first ETFs that came out were good products," says the author of The Four Pillars of Investing: Lessons for Building a Winning Portfolio. "The Spider is a great product; Vanguard's Vipers are great products, and Barclay's iShares are, too. But it's gradually gone down hill. The fees are increasing, the spreads are increasing, the marketing's increasing and so is the starting up of hot funds."
PowerShares, WisdomTree and other new-generation ETF companies beg to differ. Each fund business believes it's adding value. The fact that money's pouring into the new products suggests there are more than a few investors who agree. Yet the surge of new funds threatens to overwhelm. "The biggest risk is that there are so many ETFs that it gets confusing," says Barry Ritholtz, chief market strategist at Ritholtz Capital Partners, which uses ETFs in clients' portfolios.
Ultimately, a secular bear market on Wall Street may temper the zest for new funds. There will be a limit to how many new ETFs the market will tolerate, even in the best of times. But it's not yet obvious where that limit lies.
"At the end of the day, the market's going to determine when too much is too much," says the Amex's Ebner. "But I don't think we're anywhere near that for ETFs."
James Picerno (email@example.com) is senior writer at Wealth Manager.