The past year was an exciting one for the ETF industry, as assets continued to surge (recently passing the $1 trillion mark), new and innovative products hit the market (now nearly 1,100 U.S.-listed ETPs), and the pipeline continued to fill with exciting ideas and new issuers. But 2010 wasn’t all sunshine and roses for the ETF space; there were some growing pains along the way, including (generally baseless) accusations against exchange-traded products, some regulatory uncertainties, and a number of fund closures. Before we look ahead to what may be in store for 2011, we take a look back at the stories that made headlines in the ETF industry in 2010:
10. Price Wars
As interest in ETFs continues to build, competition between issuers for market share has intensified. Whereas mutual funds compete primarily on the basis of performance, the passive nature of most ETFs makes those comparisons less meaningful, and as a result many issuers have sought to differentiate their products by appealing to cost-conscious investors.
The price wars of 2010 got underway at the very beginning of the year when Vanguard cut expenses on VTI to just seven basis points, making its broad-based U.S. equity fund the cheapest on the market. Schwab responded in June by slashing expenses on six of its funds, including a reduction in SCHB’s fee to 0.06%. When Vanguard debuted a lineup of equity ETFs linked to S&P indexes in September, the new offerings included an S&P 500 ETF (VOO) priced at 0.06%–tying SCHB for the title of “cheapest ETF” and undercutting existing offerings from iShares and State Street. VOO recently had about $250 million in assets, suggesting that the lower expense ratio is attracting investors.
iShares also made a price reduction in an effort to gain ground in the gold ETF space; the COMEX Gold Trust (IAU) now costs just 0.25%, compared to 0.40% for the ultra-popular GLD. The iShares fund has begun to eat into GLD’s market share, though the Gold SPDR still has about ten times the assets of its cheaper competitor. Other issuers got in on the game in 2010 as well; Van Eck cut expenses on three international ETFs in June, and Old Mutual reduced fees of its emerging market ETF to 0.25% (that didn’t work out so well; the issuer has since pulled out of the U.S. market completely).
Investors have obviously benefited from price wars, and are no doubt hoping that downward pressure on expense ratios continues in 2010.
9. Free ETF Trading
Expense ratios weren’t the only component of the ETF cost equation to come under pressure in 2010. After Schwab (SCHW) marked its entrance into the ETF industry in late 2009 with commission free trading on Schwab ETFs, several other issuers followed suit in 2010. Vanguard quickly sought to level the playing field with its low cost rival by introducing commission-free trading on Vanguard ETFs for Vanguard clients (Vanguard currently offers more than 60 ETFs, while Schwab offers just 11 funds). iShares also made several of its most popular ETFs eligible for commission-free trading, partnering with Fidelity to offer a program that includes 25 of the largest iShares ETFs.
Arguably the most comprehensive commission-free ETF trading program was introduced by TD Ameritrade (AMTD), which partnered with Morningstar (MORN) to identify more than 100 ETPs from a handful of different issuers to include in the commission free program. Recently, a unit of Scottrade made a filing detailing plans for a line of domestic equity ETFs, prompting speculation that the firm is scrambling to match the offerings of its competitors.
8. Weighting Methodologies In Focus
As indexes have been transformed from hypothetical benchmarks used to measure active managers to (essentially) investable assets, investors have begun to scrutinize the construction and maintenance methodologies a bit more closely (and rightfully so). As a result, some have proposed that market capitalization weighting–which gives the biggest weights to the companies with the largest market capitalizations–has some rather serious flaws as an investment strategy. There are now a handful of ETFs offering easy, efficient access to alternatives to cap-weighting–essentially new ways of slicing up equity markets and packaging individual stocks into an equity ETF.
Alternatives to market cap weighting are nothing new; certain investors have embraced equal weighting for decades as a preferred methodology. But investors are creatures of habit, and some of those that gravitated towards cap-weighted benchmarks when making the switch to ETFs have been hesitant to go with a lesser known (and often more expensive) strategy that doesn’t seem to differ considerably from the status quo. Perhaps 2010 will be remembered as a turning point in how investors think about weighting methodologies, as several alternative weighting strategies have delivered big gains this year. Through December 21, a review of the various large cap domestic equity funds showed revealed the ultra-popular SPY–linked to the cap-weighted S&P 500–to be the laggard. And the considerable gaps between alternative products–the equal weighted RSP had beaten SPY by about 500 basis points–clearly shows that the weighting methodology can have a big impact on bottom line returns [see the Case For Equal Weighting]
|S&P Equal Weight ETF (RSP)||Equal||21.0%|
|FTSE RAFI U.S. 1000 (PRF)||RAFI||19.0%|
|RevenueShares Large Cap ETF (RWL)||Revenue||16.2%|
|WisdomTree Large Cap Dividend (DLN)||Dividend||14.3%|
|S&P 500 SPDR (SPY)||RSP||14.1%|
|WisdomTree Earnings 500 Fund (EPS)||Earnings||12.7%|
7. Refining Commodity ETFs
Commodity ETFs have had an up-and-down 2010. From a performance perspective, this corner of the market has been red hot; a combination of a weaker dollar, string demand from emerging markets, and a number of supply shortages have boosted prices of everything from corn to sugar. But inflows into commodity ETPs have fallen off considerably from 2009; excluding physically-backed gold ETFs, commodity ETPs actually saw net outflows through the first 11 months of the year.
Part of the drop-off in interest may be due to frustrations with performances turned in by the “first generation” of commodity products; funds that utilize futures-based strategies often won’t line up perfectly with changes in the spot price of the underlying commodity over extended periods of time. While the performance of these ETFs is as should be expected from any futures-based strategy, some investors have nevertheless expressed frustration with the “performance gap” relative to a hypothetical spot return.
The last twelve months have seen some impressive innovations in offering exposure to commodity prices; a number of ETFs offering exposure to stocks of companies engaged in the extraction and production have debuted, and the market reception has been generally very warm. And recent debuts haven’t been broad-based in nature or focused on just gold and oil; ETFs targeting rare earth metals (REMX), lithium (LIT), uranium (URA), and platinum miners (PLTM) were among the new ETFs to 2010.
Recent months have also seen the launch of a “third generation” commodity ETF linked to an index that incorporates research on the relationship between the slope of the futures curve and potential inventory shortages. USCI–hailed as a “contango killer”–has delivered some impressive early results, crushing many of the broad-based commodity ETPs since its debut earlier this year. Separately, at least two issuers have filed for SEC approval on physically-backed copper ETFs, suggesting that the commodity ETF space will continue to evolve in 2011.
6. ETF Closures Accelerate
After years of rapid-fire expansion that saw some issuers seemingly roll out any product that came to mind, predictions for a wave of ETF closures have become increasingly common. And while 2010 saw continued growth in the ETF product lineup–more than 200 new funds launched–it also saw its fair share of closures. More than a half dozen issuers–including Direxion, PowerShares, Javelin, Grail, Claymore (now Guggenheim), Rydex, and WisdomTree–shuttered ETFs at some point in 2011, and two more issuers, Geary Advisors and GlobalShares, exited the U.S. ETF industry altogether.
This trend also seems poised to continue into 2011; at the end of November, more than 350 ETFs had assets of fewer than $25 million–a rule-of-thumb break even point for ETF issuers. While some of these funds in the bottom AUM tier are new products just hitting their sweet spot, others have been around for a while and seem unlikely to ever gain much traction.
5. Big Year For The Little Guys
Much has been made of the top-heavy nature of the ETF industry, where four issuers account for about 85% of total assets and the 25 largest ETFs combine to take nearly 50% of the market share. While the big players may continue to dominate, it is a number of smaller ETF issuers that have seen the most impressive growth in 2010 thanks to generally warm receptions to various niche products. Among the “big four” of iShares, State Street, Vanguard, and PowerShares, only Vanguard has seen its market share increase over the last year–thanks in part to its reputation as a low cost provider.
Several smaller ETF issuers have grown exponentially in 2010. Global X finished November with more than $1.1 billion in assets, up from a paltry $11 million a year earlier. EGShares finished November north of $350 million, a nearly tenfold increase from a year earlier. Van Eck, WisdomTree (WSDT.PK), ALPS, and RevenueShares also saw market share surge over the last 12 months, indicating that investors are beginning to embrace the more unique and more targeted products offered by the industry’s smaller players.
4. MLP ETPs Booming
When 2009 was drawing to a close, many investors anticipated that interest rates would begin to climb higher at some point in 2010 as a recovery took root and inflationary pressures materialized. But with 2011 just around the corner, interest rates remain close to record lows and seem poised to stay there for the foreseeable future. That has sparked interest in asset classes capable of delivering attractive current yields, and as a result the MLP ETF space has exploded over the last year.
MLPs generally make material distributions, and the stability of these cash flows has made this once overlooked corner of the domestic energy market an intriguing option for yield-hungry investors. And many have embraced exchange-traded products as an efficient means of accessing the sector. UBS has led the way in the build out of the MLP space, rolling out exchange-traded notes linked to the Alerian MLP Infrastructure Index (MLPI), a monthly short MLP ETN (MLPS), a 2x monthly long ETN (MLPL), and a natural gas focused MLP ETN (MLPG). Other innovations have come from ALPS, which debuted AMLP, the first exchange-traded fund to offer exposure to the MLP sector (products from JP Morgan and UBS are all structured as exchange-traded notes).
According to ETFdb's ETF screener, there are now eight different products offering exposure to the MLP sector, with aggregate assets of more than $3 billion. All but one of those products (AMJ) debuted in 2010, meaning that MLPs accounted for a nice chunk of the industry’s total growth in 2010.
3. Active ETFs Still Struggling
The last year saw the launch of several actively-managed ETFs, ans some of the new products have generated a fair amount of interest. WisdomTree’s active emerging markets debt ETF (ELD) debuted in August, and will finish the year with more than $500 million in assets. The Cambria Global Tactical ETF (GTAA) is another recent addition that has raked in assets; the fund managed by the authors of the influential book The Ivy Portfolio debuted in late October and already has more than $65 million in assets. And bond fund giant PIMCO has seen interest in its four active fixed income products, demonstrating that
But for the most part, 2010 was another slow year for active ETFs. Assets in actively managed equity ETFs are just north of $100 million, despite the fact that many of the products have been on the market for several years now. Though some performances have been stellar, the lack of a lengthy track record seems to be keeping investors at bay [see Seven Successful Active ETFs].
It is far too early to declare active ETFs a bust, as the space still seems poised for explosive growth. More than 25 issuers have SEC filings for active ETFs, including several mutual fund powerhouses who haven’t yet waded into the ETF waters. If the Legg Masons (LM) and T. Rowe Prices (TROW) of the world begin pushing active ETFs, rapid growth would likely follow. But hurdles remain as well. An uncertain regulatory environment is one big issue, as the SEC has been slow to approve new products and has not come out with a definitive statement on the use of derivatives in mutual funds and ETFs. And the disclosure requirements continue to spook investors and issuers alike; though alternatives to the current system–such as NAV-based trading –are in the works, it figures to be years before the regulatory authorities make a dramatic shift in current policies.
2. ETF Bashing In Style
Since the ETF industry really began to take off a few years ago, the media coverage and investor reactions have been overwhelmingly positive. ETFs have been praised as a tool for cost-conscious individual investors to avoid what Jack Bogle has called the “tyranny of compounded costs,” while the enhanced tax efficiency and flexibility (i.e., ability to be shorted and traded intraday) has made them popular among more sophisticated investors as well. Exchange-traded products have also been instrumental in democratizing certain asset classes, bringing commodities, exotic emerging markets, and complex investment strategies within reach of all types of investors.
But throughout 2010, various attacks on ETFs popped up, a somewhat puzzling development that made a few investors think twice about embracing the exchange-traded structure. Among the most visible and damning critiques of ETFs to make waves in 2010:
- BusinessWeek Blasts Commodity ETFs: A cover story of BusinessWeek delved into commodity ETFs, going so far as to issue a blanket warning against these products. The piece, which chronicled the experiences of investors who experienced returns different from a hypothetical return on the commodity’s spot price. The article seemed to hint that these experiences resulted from product flaws, failing to explain the nuances of futures-based investment strategies or suggest that investors do their homework before buying into these products. In hindsight, the advice of “do not buy commodity ETFs” is somewhat humorous, as many commodities were among the best performing assets of 2010.
- Bogan Report Of Collapsing ETFs: One of the more disconcerting reports for ETF investors came from Andrew Bogan, managing member of a Boston-based asset management firm. In September of this year Bogan enjoyed his 15 minutes of fame after authoring a paper outlining a scenario under which certain exchange traded products could “collapse,” leaving investors who thought they had exposure to an asset class out of luck. “While ETFs often appear to be a benign innovation as compared to some of Wall Street’s arcane derivatives, a closer look at the mechanics of short selling ETFs (which have become one of the most prevalent securities to short) raises some serious concerns,” wrote Bogan. Unfortunately, Bogan’s musings were picked up by the mainstream media, thrusting the issue into the spotlight. Fortunately, the responses to his claims were swift and thorough; Bogan overlooked several simple mechanisms in place designed specifically to prevent his disaster scenario.
- Kaufman Report Attacks On All Sides: Perhaps the most comprehensive attack on the ETF industry came from the Kauffman Foundation in November. In a lengthy paper, two authors laid out a wide variety of alleged flaws in ETFs, ranging from their adverse impact on the IPO market to their role in increasing correlations between asset classes. Once again, the responses identifying errors in Kauffman’s logic (as well as shedding some light on the foundation’s motivation). “The claims were so broad and misplaced that ETFs were lucky not to be associated with global warming and the BP oil spill,” wrote WisdomTree President & COO Bruce Lavine.
1. Innovation, Innovation, Innovation
The ETF lineup expanded considerably in 2010, with more than 200 new products hitting the market and the pipeline continuing to fill with ideas. Some of the new additions launched in 2010 represent direct competitors to existing ETF products; Vanguard’s launch of equity ETFs linked to Russell and S&P indexes certainly falls into this category, as do several of the new products introduced by Charles Schwab and others. But for the most part, expansion in the ETF industry continues to be driven by innovation, not duplication. Many of the new funds to debut in 2010 were first-to-market products, offering exposure to an asset class, region, or investment strategy not previously available through the exchange-traded structure.
A small sampling of the ETF innovation in 2010 includes:
- Target Date Municipal and Corporate Bond ETFs
- Physically-Backed Platinum (PPLT) and Palladium (PALL) ETFs
- Equal Weight Emerging Markets (EWEM) and EAFE (EWEF) ETFs
- Small Cap International Equity ETFs (SKOR, SCIN, CNDA, LATM…among others)
- Copper Miners (COPX) and Silver Miners (SIL) ETFs
- Emerging Markets Consumer (ECON) and Brazil Consumer (BRAQ) ETFs
- Philippines ETF (EPHE)
- MLP ETNs/ETFs (as profiled above)
- Long/Short RAFI ETF (RALS)
There has been some debate as to whether the ETF industry is in need of a wave of contraction or continued expansion. It seems most likely that both are in the forecast. The impressive success of many of the new products launched in 2010, as well as the promising funds expected to debut in 2011, indicates that there are clearly still some stones unturned. Still, some of the products launched in recent years that have failed to generate significant interest will likely fall off in coming years, as the ETF industry undergoes an accelerated evolutionary process.
Disclosure: No positions at time of writing.
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