ETFs: What New Trends Mean for Investors

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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 IndexUniverse.com, 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.

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