ETFs: past, present and future(?)

First let’s start with some background material. There are basically two types of funds: (i) Open End Funds (what we usually think of as mutual funds), units of which can be continuously bought/sold directly from the distributor/manager for the NAV (Net Asset Value), and (ii) Closed End Funds (CEF) units of which can be bought when the finite number of shares are issued as an IPO and afterwards they can be bought/sold on the stock exchange during trading hours like any other shares. CEFs can trade at or above or below NAV. I won’t discuss pros and cons of open and closed end funds at this point. Certain asset classes were/are accessible as CEFs (and mutual funds) but not yet as ETFs.

Open end mutual funds come in various flavors, but the simplest categorization would passive/index funds and actively managed funds. As indicated earlier, these mutual funds can be bought/sold at NAV at the end of the trading day, with or without transaction fees. ETFs started out in the early 90s aimed at tracking an index (like an index mutual fund) but trading on an exchange throughout the day (like a CEF or a stock) very close to the NAV of the underlying constituent shares.

The Financial Timeshas a section on ETF related articles aggregated essentially to provide both a tutorial and an update as to how ETFs and ETF-like securities are revolutionizing the investment landscape. (This is especially true for Canadian investors as ETFs open the door to low cost access to a variety of asset classes that would otherwise be beyond their reach or only reachable via high MER mutual funds).

The lead article giving a good overview is “ETFs: winning concept’s meteoric rise” . The major players in the ETF space are Barclays, Vanguard, State Street (the pioneers), but many smaller players are trying to muscle in with specialized offerings. In theUS there is $410B. The number of ETFs has grown during the past year from about 200 to 350, and many more are in the works.

So why so may ETFs? What started out a very simple index instrument with the additional feature of being tradable like any stock is evolving rapidly into much more complex (and likely expensive) instrument including not just capitalization weighted  country, regional and sector indexes. Remember the benefits of the traditional capitalization weighted index funds: low management fees, low turnover resulting in low transaction costs and lower taxes; with ETFs you get the additional benefit of being accessible/tradable, reasonably close (not guaranteed) to NAV, throughout the trading day. But things are changing as the number of ETFs are proliferating. First fixed income ETFs were added to equities. Unlike five or so years ago, when I started seriously using ETFs as my investment instruments, today ETFs cover most asset classes needed to create a well diversified portfolio. Canadian ETFs tracking foreign markets are available in currency hedged flavor.

New Flavors of ETFs

The past year saw the appearance of ETFs in many flavors: fundamental, quantitative/intelligent, leveraged, short, ETNs, etc. Here are the differences and the direction in which ETFs are evolving:

Original – Capitalization weighted indexes like SPY tracking S&P 500 index, VTI tracking Wilshire 5000 index, EFA tracking Europe/Asia/Far-East index or EEM tracking emerging markets index. There are also different indexes covering same regions or sectors and often slightly different corresponding ETFs. As time goes on more ETFs are added by slicing and dicing market into smaller and smaller segments. More recently assorted fixed income, commodity, sectors (property, financials, telecom, etc) indexes are tracked as well. The traditional cap weighted approach has low turnover but risks overweighting already overvalued stocks.

Fundamental– weighting based on revenue, book value, cash flow, dividends etc overcomes problem of overweighting in overvalued stocks at the expense of higher turnover (and management fees, transaction costs and taxes). These appear to have been able to generate about 200bp additional return over capitalization based indexes, looking back at historical data. As a result Fundamental ETFs’ popularity appears to be growing rapidly.

Quantitative/intelligent– designed to track some quantitative screen e.g. market sentiment, patent index, spin-off index or other “intelligent index”

ETN – tracking futures in commodities, exchange rates. Commodity indexes etc.. not really ETF like in structure but also tradable on the exchange

Active– just like mutual funds where qualitative factors based on a manager’s judgment are used instead of or in addition to some of the others above. None exist as yet due to regulatory issues to be resolved.

Advisor class (only in Canada, not permitted by regulators in the US)- Claymore, in addition to their common units, e.g. CRQ their Canada Fundamental index with MER of 0.65% (already high compared to capitalization weighted index, but if they can deliver 200bp or 2% extra return then are still worth it), have added advisor class units, e.g. CRQ.A which is same ETF but which pays advisors 0.75% trailer fees and has a MER of 1.4%. Financial Post’s Chevreau in

“Claymore unit sees big growth on ETFs” covers other niches introduced in Canada by Claymore.

ETF problems?

As the ETF space is being sliced and diced into smaller and more esoteric niches:

-requiring higher turnover, higher transaction fees and higher taxes

-attracting higher MERs

-adding active ETFs in the future

-adding advisor class versions with trailer fees

will the very essence of what ETFs are about being eroded bit by bit?

There is debate about how serious is the traditional capitalization weighted ETF’s weakness of potentially becoming overweighed with overpriced stock (The classic example usually given is that Nortel became over 30% of the TSE index; today you can buy a capped index with maximum exposure to any one stock).

Also, when selecting ETFs to cover some specific asset class (or objective) it is a good idea to pay attention to liquidity of the various options available, as measured by the daily volume on the stock exchanges. This is to maximize the probability of fair pricing on buy and sell orders. As the niches get narrower and narrower, the resulting ETFs will have lower liquidity as well

Globe and Mail’s Carrick in

“Attack of the hedge funds may roil ETF markets” points out that starting in April hedge funds will be able to buy ETFs by putting down just 15% of the value instead of the current requirement of 50%. These hedge funds which are already big ETF users will increase their ETF trading even more with the likely result of significantly increased volatility (i.e. risk) of ETFs.

Summary

So you may ask “are ETFs a threat to mutual funds?” while $400B represents less than 10% of the assets invested in mutual funds, the asset growth rate of ETFs is much higher than mutual funds. As investors get educated about the ETF benefits, their growth will affect mutual fund assets under management.

So while ETFs offer great opportunity for the investors burdened with high cost mutual funds, the ETF waters must be navigated with care.

Update July 21, 2008- I received an excellent article by Ken Hawkins on ETFs at Investopedia  http://www.investopedia.com/university/exchange-traded-fund/default.asp

that you may wish to peruse as well.