February 2008

EXCHANGE-TRADED FUNDS: Next-generation ETFS wait in the wing

2008 could see the first actively managed ETF, among other innovations. Does this signal a big year for the products? Nick Fitzpatrick reports 08_02_daniel_freedman.jpgExecutives at iShares, the exchange-traded fund (ETF) business of Barclays Global Investors, believe that market volatility in the closing months of last year boosted its business and played a part in the firm’s record inflows. Jennifer Grancio, head of iShares distribution, Europe, said that the firm saw strong demand in 2007, but demand was “even stronger” in the volatile markets of the last half of the year. The company didn’t give a precise number for asset flows during this latter period, but over the year as a whole, iShare’s assets under management increased by a “record” 45% to $414 billion (e280bn) globally. And the recent market volatility will have a lasting affect on ETF sales, believes Daniel Freedman, a director at SPA ETF, another ETF provider. He says: “Given the recent market volatility, ETFs’ ease of tradeability should prove attractive to investors in 2008 as they will need to work harder to generate returns than in previous years.”

Catch up
The seemingly rosy outlook for ETFs is also partly reflected by a more impartial source, namely Roger Urwin, global investment head at Watson Wyatt, who expects a resurgence of index-based asset management, of which ETFs are a part. ETFs are baskets of securities, typically linked to an index, and which can be traded on a stock exchange as though they were one share. Offering exposure to countries, sectors and commodities, they were introduced later to Europe than the US, but Freedman expects Europe to catch up with the US significantly this year. In the ETF market has a whole, says Freedman, the US has 533 ETFs with $530.5bn invested in them. Europe currently has 386 ETFs with $125.9bn of assets under management in them. Driving growth in the sector, believes Freedman, is investors’ disappointment with the poor performance and high fees of certain active funds. This is something that Watson Wyatt’s Urwin expressed also, and significantly a report last month by TABB Group (Performance Anxiety: A Buy-Side Study of Benchmarks and the Investment Process) said that with nearly $1 trillion currently invested in the United States in index-based products, active fund managers stand to lose approximately $12bn a year in potential management fees dueto interest in index management. TABB described that as “a serious danger to the active management community”.  Freedman says: “A likely milestone for 2008 will be the advent of the first actively managed ETF being launched in the US. The efficiency which has helped establish the ETF platform may attract existing providers of actively managed funds to the ETF arena, as they look to protect their market share.”

The next generation
This next-generation of ETFs will be sought out by early-adopter investors who have become familiar with traditional ETFs, Freedman thinks. As a sign of things to come, perhaps, in January, Lyxor Asset Management announced the launch of four ETFs that give access to fundamental indices – an alternative to traditional market-cap-weighted indices. The ETFs are linked to FTSE RAFI indices, which cover the key areas of the US, Europe, the Eurozone and Japan. Similarly, SPA MarketGrader ETFs utilise the performance of fundamentally-driven indices created by US research company MarketGrader to access a broad universe of US equities. “SPA ETF has witnessed growing interest from investors looking for an alternative to actively managed investment products and this year we expect to see a substantial growth of assets under management across the sector. In response we expect to see many more launches of ETF products from providers,” said Freedman. © fe February 2008

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