Last year was a very interesting one for the ETF industry, a stretch filled with both ups and downs. The industry suffered from numerous attacks that concerned investors about the possibility of an ETF collapsing and the role that these securities played in the Flash Crash. Yet many dismissed these claims as fear-mongering, and shrewd investors continued to pile into ETFs as a way to reduce expenses, achieve more diversified exposure, and enhance the overall tax efficiency of their portfolios. In fact, ETF assets recently surged to the $1 trillion level, while the number of fund choices continued to expand as well, hitting the 1,100 mark.
The past year was no doubt one of the most important in the industry’s short history, as the products continued to gain market share in new markets around the world. With 2011 well underway, the new year figures to be full of exciting developments for the industry as well. Below, we highlight several predictions for the ETF industry in 2011, our thoughts on what headlines might shape the next phase of the ETF boom.
Okay, so this is an easy one. The two most popular emerging market investments continue to thoroughly dominate the Emerging Market ETFdb category, combining to account for more than $90 billion of the $110 billion or so in total. Both of the funds track the MSCI Emerging Markets Index, and as a result are largely similar in terms of composition and individual weightings. The most significant difference between the funds – besides the issuer name – is that VWO charges an expense ratio that is roughly one-third that of EEM. As a result, cost conscious investors have been piling into Vanguard’s VWO instead of iShares’ EEM; VWO saw cash inflows of more than $19 billion in 2011, compared to $2.3 billion for EEM. Look for VWO to finally surpass EEM at some point early this year.
This development will underscore the importance of low fees to ETF investors, and perhaps inspire other firms to slash their expense ratios in an effort to gain market share. There are several match-ups where cost differentials could be critical to future growth, including the head-to-head gold ETF match-up as well as a variety of country-specific ETFs. Undoubtedly, the battle between VWO and EEM is one of the most important head-to-head confrontations of the year, and many ETF issuers will be watching this situation closely for guidance on how best to proceed with their lineups.
2. New Country ETFs Debut
This past year saw the release of several country ETFs targeting once hard-to-reach international markets; countries that are now available in ETF form include the Philippines (NYSEARCA:EPHE), New Zealand (NYSEARCA:ENZL), and Egypt (NYSEARCA:EGPT), just to name a few. Moreover, a number of additional products appeared in other markets such as India and Brazil, targeting unique aspects of their respective economies. We look for this trend to continue in 2011 as investors seek greater levels of granularity in their investment portfolios and look to more "frontier" countries that may offer uncorrelated returns and the potential for significant long-term growth. Possible additions to the country lineup include Argentina, UAE, Pakistan, Hungary, and Greece.
3. Volatility ETNs – But Not the Traditional VIX
Last year saw a surge in the number of products offering exposure to volatility, an asset class that was previously beyond the reach of many investors. While all of the VIX ETPs currently on the market are linked to indexes based on the volatility of the S&P 500, there seems to be an opportunity in harnessing the volatility of other equity benchmarks and even other asset classes. Currently, there are VIX levels for oil, gold, and a variety of other commodities and indexes as well. Given the popularity of the current crop of VIX ETNs, it is rather odd that no one has thought of this yet, especially considering the often significant volatility of gold and oil. These products could become popular choices for investors seeking to hedge exposure to commodities or for those who have large holdings in oil companies or gold mining firms.
4. Small-Cap Europe ETFs
IndexIQ, the firm perhaps best known for its hedge fund replication ETFs, has been one of the few firms to offer investors quality exposure to small caps in foreign markets. Their four core small cap funds, which target the small cap securities in Australia (NYSEARCA:KROO), Canada (NYSEARCA:CNDA), Taiwan (TWON), and South Korea (NASDAQ:SKOR-OLD), have been slow to build assets despite the fact that they arguably offer more “pure play” exposure to the local economies and tend to not be as prone to heavy exposure in oil and banking firms as their large-cap peers. Investors have begun to embrace small caps as a critical component of international equity exposure, and this trend should continue going forward. While there are small cap ETFs offering exposure to many of the world’s largest economies, there is room for further innovation as well.
For example, only one ETF offers direct exposure to small-cap European equities: the WisdomTree Europe SmallCap Dividend ETF (NYSEARCA:DFE). The fact that a small-cap Germany ETF doesn’t exist yet seems like a good opportunity, especially considering that small-cap ETFs targeting China (NYSEARCA:HAO), India (NYSEARCA:SCIN) and Japan (NYSEARCA:SCJ) are already present and have all generated significant interest from investors. Furthermore, since European countries tend to have pretty developed capital markets, a small-cap fund would not be starved for choices as it might be in some less-liquid emerging markets, allowing investors to obtain exposure to an interesting corner of the market that remains untapped. IndexIQ has filed for several such funds, and we look for their issuance to start a new trend of foreign small-cap investing later this year.
5. At Least 50 ETFs Close
While there will almost certainly be a net gain of funds in the ETF world this year, it is undeniable that many ETFs are money losers for their issuers. More than 450 ETFs finished 2010 with less than $50 million in assets, a common rule-of-thumb breakeven point in the ETF industry. Although many of these funds are relatively new products that are still hitting the sweet spot on their growth curve, many of them have been around for quite a while and are unlikely to suddenly see a surge in assets. As issuers look to cut the fat from their product lineups, look for at least 50 ETFs to close down this year.
6. 2011: Year Of the Non-BRIC Emerging Market ETF
If 2010 was the year of the commodity ETF, 2011 will be the year of the non-BRIC Emerging Market ETF. After billions of dollars flowed into BRIC-focused ETFs last year, expect investors to look towards smaller or lesser-known emerging markets in 2011 as an option to move away from U.S. exposure and identify markets poised to deliver solid long-term results. These nations, ranging from Indonesia to Chile, also tend to be far less correlated with Western equity markets than their BRIC counterparts, potentially offering valuable diversification benefits as well.
Although many investors might believe that they get plenty of exposure to these countries via broad emerging market funds, this is really not the case. VWO and EEM both maintain more than 45% of their portfolios in the BRIC nations, with another 33% or so in the quasi-developed markets of South Korea and Taiwan.
7. More Online Brokerages Jump on the ETF Bandwagon (I’m Looking at You, E-Trade)
As further evidence of the growing importance and recognition of ETFs, numerous brokerage houses announced plans to offer many ETFs commission-free to their clients, a development that may accelerate the shift from mutual funds to ETFs among individual investors. With the recent proposal of a revived FocusShares, it appears that Scottrade will likely join the growing chorus of online brokerages to offer commission-free trading on a number of products to their clients.
As a result of this intense competition, we believe that several other online brokerage companies, such as E-Trade, will have no choice but to announce similar programs for the clients or risk falling behind their more ETF-friendly counterparts.
8. India ETFs Catch Up to China ETFs
While China may still be an emerging market, its ETF lineup is highly developed; currently over 150 ETFs offer at least some exposure to the country, with 16 putting a majority of their assets in Chinese stocks. This number increases even more if investors add in auxiliary China exposure in the form of Hong Kong securities or those from Taiwan. This is in sharp contrast to the situation in India, where just 43 funds offer exposure to the country and just five have more than half of their assets in the sub-continent. In fact, more funds offer exposure to either Peru or South Africa than India, the world’s most populous democracy.
As China approaches a possible slowdown in 2011 and ETF issuers begin to see that the Chinese ETF market is saturated for the time being, many will set their sights on India as the next big area of growth for their product lineups. Amazingly, only one sector-specific Indian ETF exists -- INXX -- suggesting that there is opportunity for a more robust offering of India funds.
9. Active ETF Push Continues
With ETF assets hitting $1 trillion in late December, the vast majority of assets continue to be in "plain-vanilla" funds tracking standard indexes such as the S&P 500 or the Russell 2000. Active ETFs, once billed as the “next big thing” in the industry, have been slow to catch on with investors. Grail, the San Francisco firm behind one of the first true active ETFs, recently indicated in an SEC filing that it is on the verge of a sale or liquidation. While a handful of active PIMCO bond funds have had some success, assets in active ETFs have generally been disappointing.
Despite the slow start, expect the active ETF lineup to continue to grow in 2011. More than a dozen companies, many of them big players in the mutual fund space, have laid the groundwork by filing for exemptive relief with the SEC. Some believe that these companies (the T. Rowe Prices (NASDAQ:TROW) and Legg Masons (NYSE:LM) of the world) are merely taking precautions in case the ETF boom accelerates. But as soon as one or two of them wade into the ETF waters, expect an all-out deluge.
10. More Funds in the Underdeveloped Currency and RE Categories
Despite the massive markets that exist in both the foreign currency and real estate worlds, the number of ETF products in these two categories leaves much to be desired. Just 14 funds track the real estate market in the U.S., while just 11 exist in the Global Real Estate ETFdb Category. While the currency ETP lineup is comparatively more robust with 30 funds, it is pretty small when one considers that over $2 trillion trades hands every day in the currency market, suggesting that far more potential exists in this slice of the market as well.
On the real estate front, we look for more targeted exposure, both in terms of real estate sectors and geographic locations, to hit the markets this year. Funds focusing in on real estate in various countries such as Canada or Japan could be a big hit with investors seeking more international real estate exposure, while more segmented exposure to the U.S. market could be value-added as well. For currencies, some of the world’s most important currencies remain without a pure play ETF, so we look for continued expansion, particularly from emerging nations in Asia and South America, in 2011.
11. VIX ETPs Contraction
The end of 2010 saw the launch of numerous funds targeting the suddenly-popular volatility play in the market. However, these funds are largely similar, tracking various stretches of the S&P 500 volatility index curve, and are best suited for sophisticated investors making short-term trades or hedges. As a result, we predict that some VIX ETNs will close and that issuers will come to see that this is probably an oversaturated market in its current form. This is especially true given the domination by VXX over its competitors in the volatility space; the fund makes up over 61% of the total assets in volatility securities and a whopping 85% of the category’s volume. This suggests that it will be very hard for new entrants to break in and chip away at its market share, given how important volume is to this category. This isn’t to say that VIX ETNs aren’t a good idea or a great tool for those seeking inversely correlated exposure; it is just that too many exist tracking the S&P 500, with minimal choices available to investors for anything else.
Disclosure: Eric is long VWO.
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