Balance of power shifting in favour of investors

The following is extracted from a paper by Andrew Houston, co-founder – Amba Research entitled ‘Challenges and Opportunities as the ETF Market Matures’:

How the ETF market has grown

Global ETF issuance has accelerated in the past six years. The market value of issued ETFs rose at 28% per annum over five years to December 2010. According to research by BlackRock, the largest ETF issuer in the world, by March 2011, the global ETF industry had assets worth US$1.4 trillion with 2,605 ETFs listed on 48 exchanges around the world (Figure 1).

The ETF market is dominated by the top three issuers – BlackRock (iShares), State Street Global Advisors (SSgA), and Vanguard (Figure 2). Collectively, these three firms have a market share of almost 86%. iShares is the dominant provider in the ETF market with a 44% share, amounting to over US$609 billion assets under management (AuM), followed by SSgA with 14% and Vanguard with 12%.

One hundred and thirty two issuers share the remaining 14% of the market, managing a total US$195 billion, a relatively paltry US$1.5 billion per firm. A further 38 firms have announced plans to enter the market.

ETF market expanding globally

The US dominated the ETF issuance market over 2000-10. Equity ETFs still dominate the landscape, comprising approximately 80% of global ETFs. Figure 3 depicts the geographic distribution of Equity ETF assets under management (AUM). While North America remains the biggest player, emerging market (EM)-focused ETFs have grown significantly to form about 21% of global equity ETFs.

Types and categories

The major categories of ETFs are equity, fixed income, and commodities (Figure 4). Equity ETFs are by far the largest category and comprise approximately 80% of global ETFs. Alternatives, currency and mixed comprise a negligible share of currently issued ETFs.

In recent years, investors seeking higher returns have demanded more innovative structures compared with index-tracking ETFs. There has been growth (Figure 5) in the issuance of synthetic ETFs that use derivatives to replicate index performance (such as swaps, futures, forwards, and options) compared with physical replication. Physical replication of ETFs refers to the use of physical securities such as stocks, bonds, and commodities to generate index performance.

The demand for more innovative and higher performing synthetic ETFs has been supplemented by forces on the supply side, where there has been pressure for innovation as an increasing number of new issuers entered the market and sought to differentiate their products relative to core incumbent issuers.

The share of synthetic replication has been greater outside the US, while within the US, physically replicated ETFs have dominated. Global and US market shares of synthetic ETFs appear to have peaked in 2008, and since then a ratio of below 1 of every ten ETFs issued seems to have been maintained.

ETF selection criteria

Fund managers primarily use ETFs as a tool for quick deployment of funds and as a cheaper and liquid cash proxy to reduce tracking error while having liquid funds available for redemptions. ETFs are also used as ‘completion strategies’, according to a managing director at a leading global asset manager. For example, let’s assume that an asset manager’s institutional client follows an unusual North America benchmark, including Canada. If the firm feels it has no alpha generation track record in Canada, it would fill the mandate with its US active funds plus passive benchmark weighting in Canada using an ETF. Tactical asset allocators might also make use of commodity ETFs to take liquid short-term positions in commodity markets.

Key considerations for approving the use of an ETF by fund managers are:

 • Liquidity, and to a lesser extent price

 • Issuer brand and track record

 • Tax considerations

 • UCITS compatibility in Europe

 • Counterparty risk

 • Meeting individual fund objectives

 • Tracking error

Institutional investors find ETFs attractive as tools for cash equalisation, transition management, rebalancing, and as a quick and easy method of establishing market exposures in terms of tactical asset allocation. This is highlighted by the extensive use of ETFs in 2009-10 to gain exposure to commodities, emerging markets, bond indices, and a wide range of ‘exotic’ asset classes (see Figure 6). Fund managers see ETFs as a cost-effective substitute to entering emerging markets directly via stock purchases.

In the view of Amba Research, successful growth of the market largely depends on ETFs being a reliable proxy for the underlying index tracked. If an increasing proportion of ETFs are sold to the retail market, there are real risks of more complex instruments being sold to investors with a lack of adequate information on which to base an accurate assessment of risk.

Tracking error trends downward

Tracking error is a key investor concern when assessing the attractiveness of ETFs, especially the more exotic ETF categories and markets.

The most common sources of tracking error are known to be fees and expenses, portfolio optimisation, and index charges. In some cases, where holding deviations and material weighting are involved due to Securities and Exchange Commission (SEC) regulations, the tracking error could be higher. This is due to SEC requirements that a minimum 80% of the ETF portfolio be in securities matching the fund’s named asset class. In theory this is a good thing; in practice, in illiquid markets it may lead to deviation from the benchmark weightings. Amba Research has seen a decline in tracking error in 2010 across all markets and virtually all providers for US-listed ETFs at an average of 74bps, with a narrower range from 2009. Absent another market crash, fund manager demand should encourage the trend towards reduced tracking error. Figure 7 shows US-listed ETF tracking error by market segment.

Analysis by Morgan Stanley Smith Barney on segments of the ETF market from 2002 to 2010 show that US Major Market and US Style ETFs tracked their indices closely due to low expense ratios and cheaper to access underlying markets, leading to lower fees and less optimisation. International markets had higher tracking error than US markets as international ETFs have exposure to more difficult to access markets and thereby higher fees. Figure 8 shows the top 22 ETF providers by tracking error.