Indexing and ETF Space Headed Onward and Upward

We’ve seen a lot of big numbers both on the upside and downside in recent weeks in the markets, although in percentage terms, nothing so dramatic. Truly an active manager’s market. However, with the indexes up strongly yesterday, I also see an interesting report out from “Pensions and Investments Online” giving some interesting stats on the world of indexing. Key points:

According to Pensions & Investments’ latest survey of the leading index managers, total worldwide assets under internal indexed management by the 53 managers surveyed reached $5.17 trillion as of December 31, 2006. This is up 13.5% from the $4.55 trillion as of June 30 but when adjusted for market changes, worldwide indexed assets increased 2.7%. Thus, not a dramatic increase for new indexed assets. But clearly, some decent returns from global indexes.

The two size leaders, Barclays Global Investors and State Street Global Advisors, saw somewhat strong growth in assets: BGI reported $1.695 trillion in total worldwide indexed assets of Dec. 31, a market-adjusted increase of 0.45% over the six previous months. SSGA reported $1.517 trillion in worldwide indexed assets as of Dec. 31, a market-adjusted increase of 5.7%.

For both BGI and SSGA, the main drivers for growth were the asset classes of international fixed income, domestic fixed income and internation equities. Domestic equity saw little to slightly negative change.

Other names mentioned from the list were Vanguard, Northern Trust Global Investments, Mellon Financial and BlackRock.

The top five index managers all reported market-adjusted drops in U.S. institutional tax-exempt assets under internal indexed management. In aggregate for this group, the decrease was 4.6%. According to Corin Frost of BGI, in the institutional tax-exempt space “… we continue to see a transformation from index mandates to enhanced and active strategies.”

Furthermore, Northern Trust Global Investments saw the largest drop with a market-adjusted decreases of 12.1% in U.S. institutional tax-exempt assets. According to Robert S. Gray, director of sales at NTGI, “There has been a push for riskier products in general with more of an appetite for alpha. As a result, we are seeing money flow out of beta products such as pure indexing and into active and fundamental active products,” said Robert S. Gray, director of sales at NTGI.

One possible reason why total worldwide assets are going up but U.S. institutional tax-exempt assets are going down is that investors around the world are reducing their home-country bias and investing more around the world, according to Maggie Ralbovsky, a managing director at Wilshire Associates.

Enhanced indexed assets again saw a significant increase in assets. In the universe of U.S. institutional tax-exempt indexed assets, enhanced assets increase by 14.8% to $449.5 billion as of Dec. 31. The leading enhanced manager, BGI, saw its institutional tax-exempt enhanced assets rise by 18.5% to $150.7 billion as of Dec. 31.

Total worldwide exchange-traded funds also saw significant growth. Total ETFs reached $451 billion as of Dec. 31, an 18.8% increase from $379.7 billion as of June 30. Only $5.5 billion of that total was institutional.

My thoughts:

First, a few short comments:

1. I wish we had some data from other asset managers in this area, especially the newer ETF providers just to see how their growth in assets compare over the same period.

2. Frost’s comments on the recent increased focus on enhanced and active strategies over indexing is interesting. Perhaps it’s simply behavioral finance. After over 4 years of a bull market (at the time of the survey), investors have simply accepted risk taking to a greater degree. Many might say that pure indexing and passive management is the greater risk due to poor performance during major market declines. But from what I read in S&P’s SPIVA reports, active managers don’t really do that well in bad times for nearly all asset classes. Adding active managers is simply adding on another level of uncertainty.

To me, the key point from P&I’s report is that indexing is still a powerful force but is showing some loss in momentum. Where do we see growth? Fixed income, international markets and enhanced indexing. Also some small mention of alternative investments but not in the context of index implementation. Why does this sound familiar?

No surprise we are seeing a significant push of new ETF products in these specific areas. BGI has made the strongest push recently for more fixed income ETFs, but I hear of other providers having something in the pipe. There has obviously been a lot of product development both in North America and outside for international exposures. Enhanced indexing? Although the fundamental weighted ETFs from PowerShares and WisdomTree might not seem like it, they’re meant to be an improvement over market cap weighted indexing. I wouldn’t technically classify them as enhanced indexing but we can see in today’s environment that investors are striving harder for “better than average” returns. I suppose it’s a sign of the VIX@10 world … note that this survey was taken as of the 2nd half of 2006.

And of course, with ETFs covering private equity, commodities, real estate and infrastructure, the area of alternative investments is also within reach for investors. It’s this area, along with enhanced (and various forms of non-market cap weighted) indexing that I suspect to find the greatest growth in the ETF industry.

This is relatively good news for mutual funds and other active managers with sizeable assets. If the trend in indexing had continued its focus on tracking the traditional, low cost, broad market-cap weighted index, someone like a mutual fund company would have to bite the bullet and accept indexing as part of their investment philosophy or else chug along and hope for the best in an uncertain environment where investors don’t want to pay for sub-par performance.

But simply getting into the pure indexing space just doesn’t make sense for the many professional investors who say “we buy good stocks and we sell/avoid bad stocks” (or something to that effect). Instead of going the full 180, they can use their marketing spin to adapt a quasi-index/quasi-active approach within their current fund lineup. So, instead of seeing another Fidelity take a swing at the ETF space in the way they did, perhaps we could see something more like what Invescap did with their acquisition of PowerShares.

This sort of logic leads to what I believe is currently a very short list of acquisition targets. Frankly, the ETF provider space is still way too small for a shopping spree of acquisitions. But it wouldn’t suprise me to hear of news related to WisdomTree or Claymore being bought … just conjecture. Also wouldn’t surprise me to see a hedge fund or two get into this beating out a mutual fund. Unlike most mutual funds, hedge funds are truly in the business of alpha and hedging their bets with a little bit of beta-based returns makes perfect sense to me. Although this logic makes perfect sense to me about 5 years ago.

Anyway, from all this, we get further evidence that the direction of the indexing and ETF space is onward and upward. No signs of slowing down unless you’re focused on the traditional origins of indexing. For those focused on further innovation in this space, not only does your future look good, I think you should be preparing for a potential financial event. Only at such a point in time, if and when we see a large number of acquisitions as described here, would you see me beginning to have significant concern for the health of the ETF industry.