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ETFs: What New Trends Mean for Investors

Even after a two-month stock market rally, market volatility remains high. Simply put, investors are worried, not only over the timing of an economic recovery, but also by the possibility that the recent surge in equities may be little more than another bear market rally. The uncertainty bodes well for the popularity of low-cost exchange-traded funds (ETFs) that allow investors to jump into and out of positions with great agility throughout the trading day.

Total ETF assets increased by $49 billion, or 10.2%, for the month, to $531 billion at the end of April, according to State Street Global Advisors' (STT) April ETF Snapshot report. Since 2002, assets have increased more than fivefold, as the number of ETFs has grown more than eightfold.

The ongoing net flows of money out of open-end mutual funds and into ETFs is mainly the result of the drop in the stock market in the last few months of 2008 which "freed up the tax handcuffs" among investors, says Noel Archard, managing director for product research and development at iShares. Archard points out that investors stood to incur a much smaller tax bill, if any, from pulling money out of conventional mutual funds after the market downdraft. The poor performance by many mutual funds, coupled with the capital gains distributions they had to pay out, only added to investors' eagerness to shift into tax-efficient ETFs, he adds. He estimates that roughly $170 billion in assets migrated from mutual funds to ETFs last year.

Barclays Isn't Leaving Completely

There's been no shortage of headlines around ETFs lately, from Barclays' announced $4.4 billion sale of its prized iShares franchise to private investors, to the debut of what's being billed as the first truly actively managed ETF by Grail Advisors, a division of merchant bank Grail Partners in San Francisco. But at least some financial advisers who invest heavily, and in some cases exclusively, in ETFs, believe these developments are far less significant than all the press coverage would suggest.

There's little chance that iShares' new owner will raise expense ratios, as some people fear, in view of the competitive pressure from the other two big ETF providers, Vanguard and State Street Global Advisors, says Scott Kubie, chief investment strategist at CLS Investments in Omaha, Neb. He believes the sale is motivated more by Barclays' need of capital to shore up its balance sheet and its preference not to take money from the British government than anything else.

Indeed, Barclays will still have a presence. The way the deal is structured, with Barclays retaining a major debt stake in iShares, seems to allow for it to be bought back in a few years' time, says Richard Ferri, CEO of Portfolio Solutions in Troy, Mich.

Lots of Interest in the Grail ETF

The Grail ETF has attracted attention, but the new offering may find it hard to gain wide acceptance since to date actively managed ETFs have found it very difficult to attract assets, with no track record and no big-name portfolio manager behind the product.

Ferri, who is also the author of The ETF Book: All You Need to Know About Exchange-Traded Funds, regards the various actively managed ETFs introduced by smaller players more as experiments than serious marketing efforts. For these ETFs to really take off, a big, retail-oriented mutual fund company like Pimco needs to launch one headed by a big brand-name manager who's committed to using that strategy exclusively in an ETF format, he says.

The main reason that's not likely to happen is big-name mutual fund managers wouldn't want to cannibalize their own business. Fund managers also want to get the broadest possible distribution for a new fund and that's not possible without access to the 401(k) market. The problem is there's no brokerage platform within a 401(k) that allows for trading throughout day since the plan managers do all their trading at the end of the day, says Ferri.

Trying to Recoup Last Year's Losses

The concept of full transparency for ETF holdings makes less sense for actively managed ETFs, too. It's important to provide the tax benefits of an indexed ETF, but imposing full transparency on a portfolio could limit the moves a manager wants to make because he's concerned about being front-run by other investors, says Archard at iShares.

Leveraged ETFs that double or triple the daily return of an underlying market index, or a negative multiple of the return for inverse ETFs that move against the index, have garnered a lot of attention, especially due to interest in recouping last year's losses. But more prudent investors have begun to realize that these are best used as day-trading vehicles, to be held no more than a day or two, since they need to rebalance daily and may not actually track the underlying index over the longer term.

"Most advisers plan allocations based on long-term risk and return projections, so if you put something in a portfolio that you don't know [what the return's likely to be], you don't know how to do your allocations," says Archard. The confusing outcome makes it hard for advisers to employ leveraged or inverse ETFs effectively, and that's why iShares has chosen not to launch any yet, he adds.

Betting on Housing Prices

By subdividing asset classes such as commodities into narrowly defined slices that allow for more targeted exposure, the ETF industry has been a great help to investors "who dig down to more segmented ETFs in order to take advantage of opportunities that are out there," says Kubie at CLS, which currently invests about half of its $2.8 billion in assets in ETFs.

While the ETF industry has provided access to most asset classes sought by investors for diversification in recent years, Kubie says there are still some holes that need to be filled. Two examples: international corporate bonds and higher-risk mortgage bonds that would offer higher yields than existing products based on Ginnie Mae and other government-guaranteed bonds.

That's not to say that ETF firms are neglecting to bring unique products to market. MacroShares is coming out with two new home-price ETFs that allow investors to bet on or against moves in housing prices in the biggest U.S. real estate markets. The MacroShares Major Metro Housing Up ETF (UMM) will provide triple the return of the Standard & Poor's/Case-Shiller 10-City Composite Home Price Index when the fund expires in November 2014. while the Major Metro Housing Down ETF (DMM) will deliver three times the inverse of the index's performance at expiration—essentially taking a short bet against housing prices.

Unlike most ETFs, these funds aren't designed to track an underlying index on a daily basis. Instead of holding actual home loans, they both will hold only U.S. Treasuries, which they will be required under contract to shift back and forth between the two funds based on whether the index is up or down, Matt Hougan, the editor of, explained in an article on that Web site.

The inverse fund "is an institutional product that a bank could use to hedge the risk in its portfolio of mortgage loans," says David Elan, a principal at Boston-based Winward Investment Management. That could mean that any gains on a bet that home prices will fall would potentially count toward the capital on a bank's balance sheet and compensate for any loan losses, he adds.

Holdings Concentrated with Big Funds

Even with the growth in the number and type of ETFs, the bulk of assets in the category are concentrated in a relatively small number of the bigger funds. At the end of March, roughly 84% of all ETF assets were held by 12% of the funds in the industry, according to State Street Global Advisors' Strategy and Research Group. Of the 735 U.S. listed ETFs, 84 have more than $1 billion in assets, while 107 funds have assets between $100 million and $1 billion each. Over 540 ETFs each hold less than $50 million in assets, due to the deluge of new entrants over the past few years, says Anthony Rochte, senior managing director at SSGA.

After adding so many new variations in recent years, what's next for the industry? Consolidation looks more likely than further innovation right now, says Elan. Several narrowly focused ETFs have closed because they weren't able to cover their expenses. On May 1, Invesco PowerShares, a top ETF sponsor, said it would close 19 ETFs. A much smaller sponsor, SPA, also said it was closing six funds.

"Like many other good ideas, Wall Street tends to push things past the margins and then they get pulled back to equilibrium or more sensible levels," he says.

ETFs, no longer the new kid on the block, may have a few growing pains on the way to maturity. But they stand ready to play a larger role in Americans' finances in the years ahead.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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