Looking into the future

Last year saw the ETF industry continue to burgeon as assets hit record highs and issuers further expanded product ranges around the world. Emma Dunkley explores what 2010 holds for the growing industry

At the end of December 2009, global assets in ETFs surpassed the one trillion dollar mark, representing a record level. The next 12 months and beyond herald greater growth, as products proliferate, issuers geographically expand their ranges, new players come to market and more investors become aware of the benefits on offer. 

ETFs are gaining traction among different types of investors partly due to the increased recognition of these funds as a product category. The wealth advisory markets are now adopting ETFs more substantially to provide asset allocation strategies through low-cost, transparent and efficient vehicles. “A few years ago, many managers would not have touched ETFs, as they saw their value added in terms of stock selection to try and generate alpha,” said Manooj Mistry, head of db x-trackers UK. “Now they are recognising the importance of asset allocation, and ETFs are the right tool for investors to implement this.”

The number of institutional users of ETFs increased at a compounded growth rate of 29.9% last year, according to BlackRock head of research and implementation strategy Deborah Fuhr. She said more investors are turning to ETFs as many find it difficult to identify managers who can consistently deliver alpha. “You should use alpha where you can find it and beta products like ETFs where you cannot. This is the way forward, and we’re seeing this in investors around the world more than we have in the past.” 

Geographical expansion

Asia is one of the regions set to develop as a significant market for ETFs as the number of investors in these funds rises. One of the factors spurring the development of these domestic markets is the need for funds denominated in local currencies. Rory Tobin, chief executive of iShares International, said: “Investors care about local currency products and those that are tax-optimised for local requirements.” He added there will be a trade off between European or American funds brought to Asia and locally developed products, which will be determined by issues such as currency, tax, and the level of liquidity provided in the time zone. 

With the potential to passport products and develop domestic funds in fledgling markets, providers are planning on expanding their product ranges further into Asia and Latin America. Tobin said iShares has teams on the ground in contact with clients in these geographies, which are seeing a greater demand for a range of products. He added: “Our strategy now is to look at what we can take to those geographies with our US and European product ranges, 

but also what we can do in terms of local products that will be set up to meet local requirements.” 

The domestic market in Latin America is undergoing substantial growth, bolstered by government entities implementing measures to support ETFs. For example, iShares worked with government entities in Peru last year, enabling Peruvian pension funds to exchange stock in local companies for the iShares MSCI All Peru Capped Index fund. Tobin said iShares has the ability to work with government entities where appropriate, to put in place legislation that can foster the use of ETFs. 

Lyxor also has product development plans for Latin America through 2010. The issuer registered 14 funds last year in Chile for domestic pension funds, including the Lyxor India ETF and a range of equity products. 

Lyxor director of ETF sales Claus Hein said: “The pension fund market in Chile is sophisticated and well developed. Over the past couple of years, Chilean pension funds have been closely following the growth of the ETF market as a whole and are now big users of ETFs for asset allocation strategies across their portfolios.” Hein added there are many potential opportunities for Lyxor ETFs in Brazil, Mexico and other Latin American markets. 

The trend towards listing products with a more local flavour will certainly emerge more prominently this year. Mistry at db x-trackers said: “We’re looking at delivering more local products, possibly more on Asian indices which are relevant to investors in Asia, although we could look to offer these products into Europe as well.” 

As investors become more familiar with ETFs tracking cap-weighted indices, they will be better positioned to broaden their knowledge of other potential underlying asset classes and benchmarks. Invesco Perpetual head of listed fund sales Tim Mitchell said although there is a trend towards gaining exposure to the emerging markets, valuations are looking costly in these regions. 

He explained this is where fundamental indices, such as the FTSE RAFI methodology, break the link between index weights and share price, in order to gain exposure to companies based on their fundamental strength. Invesco recently converted four of its Dynamic funds to track a range of FTSE RAFI indices, including the emerging markets, Asia Pacific ex-Japan and Hong Kong benchmarks.  

Fixed income and commodities remain popular

In terms of underlying asset classes, industry figures believe ETFs tracking fixed income and commodities will remain popular this year. In 2009, investors moved back into the market and up the risk scale. Fuhr at BlackRock said the majority of net new assets ($33.6bn) in Europe went into equity ETFs in 2009, followed by $13.8bn in commodity products and then $7.7bn into fixed income. In the US, the bulk of net new assets ($27bn) went into fixed income, followed by commodities. 

Fixed income will continue to be a key focus for iShares among other players in 2010. Tobin said: “We have a few fixed income products to come forward in the first and second quarter of this year. In terms of commodities, Tobin said: “From 2010 onwards, we would like to address what we can do in the commodities space and enhance our capabilities there.” 

However under the Undertakings for Collective Investments in Transferable Securities (Ucits) regime, there are certain investment limitations to ensure diversification across asset classes. Tobin said swap-based replication provides the ability to access these assets in a different way. “Although our method of choice continues to be direct replication, as it has resonated most with our clients as simple and transparent, we will look at swap-based replication this year and will expand our overall range of swap-based products at some stage.” At present, iShares has 19 swap-based funds on its Munich platform. 

Lyxor also plans on expanding its fixed income range, which currently focuses mainly on European corporate bonds and government bonds. Hein said: “We are considering new ETFs tracking other types of fixed income instruments, such as US Treasuries, Treasury Inflation Protected Securities (TIPS) and additional corporate bond products. We also plan to launch gilts and other sterling-denominated bond ETFs for UK customers.” 

Hein said he expects the use of sector ETFs to continue to increase this year for tactical asset allocation and sector rotation strategies. “At the same time, we believe emerging market ETFs will remain particularly popular for cheap and liquid access compared to other investment vehicles.” 

Regulatory support 

The popularity of ETFs is also fostered by support from regulators in various jurisdictions. In the UK, the Retail Distribution Review (RDR) set to come into effect in 2012 is propelling IFAs to consider ETFs for the first time in many cases. Fuhr at BlackRock said: “The European Union is also looking at an initiative like the RDR across Europe to enhance transparency on mutual funds, notes, structured products and on fees. This is another positive regulatory change that will encourage investors to look at ETFs.”

Mitchell at Invesco said the shift from stock selection to asset allocation among asset managers and IFAs is also in line with the fee-based advisory model promoted by the RDR. He added: “It will become increasingly apparent that investors will want low cost funds that give them the exposure they require. It’s absolutely natural that there is going to be more retail interest in the ETF industry.” 

Mistry at db x-trackers highlighted Ucits IV in 2011 will simplify the offering of ETFs, in terms of the necessary documentation, time to market and the pass-porting of funds into different jurisdictions. The development of the second Markets in Financial Instruments Directive (Mifid II) to potentially include trade reporting of ETFs across exchanges will also add transparency to the market. Tobin at iShares said: “Investors will benefit from trade reporting by seeing the depth of liquidity in the industry and understanding there is a very active two-way market. We are supportive of Mifid II including this.”

New market entrants

With the success and expansion of the ETF industry, 2010 will continue to see new providers come to market. “There’s no doubt about it, we are going to see more providers as the ETF category grows,” said Tobin. “But how successful will these players be? For a lot of them, the jury is still out.” 

As a number of new providers are launching products similar to existing funds on popular benchmarks, Invesco’s Mitchell said one implication could be an increase in competition and a possible lowering of fees. “This is going to be a trend this year, with new providers offering the same kind of products, perhaps more cheaply to gain asset traction early on.” Mistry at db x-trackers said the success of new markets entrants will depend to a large extent on how strong their distribution is, in terms of how the products are effectively sold. 

Although the long-term success of new entrants remains to be seen, their emergence into the ETF arena is testament to the growing popularity of these funds. With product issuers expanding into Asia and Latin America, increasing levels of investor education, strong asset flows and complementary regulation, 2010 is set to see the ETF market soar on a global scale.