A Growing Industry
From Mutual Funds to ETFs
The growth of the ETF industry has been astonishing. Over the two-year period ending December 2008, the number of exchange-traded products worldwide doubled to 1,590. Perhaps most impressively, while the traditional mutual fund market saw net outflows of over $250 billion (on top of market declines), ETFs had net inflows of $187 billion, keeping assets ahead of $700 billion even in the face of a 42% decline in global asset values as measured by the MSCI World Index4.
To put that figure in perspective, it took conventional mutual funds 41 years to gather $600 billion in assets after the first fund was launched in 19245 ; ETFs achieved the same just 14 years after the debut of the first ETF in 1993.
Growth has been particularly impressive in Europe. European ETF assets rose by 11% in 2008 to $142 billion and 277 new funds were launched, again, in the face of a crippling market.
The story is the same in every major financial market: Japan saw the launch of 46 new ETFs in 2008, and assets are nearly $30 billion. Asia Pacific (ex-Japan) saw 27 new ETF launches, to 95 total, with nearly $25 billion under management6.
To understand why ETFs have had such tremendous appeal across international borders, it helps to understand exactly how they differ from mutual funds, and how they are used by investors, traders and institutions. To do that, the place to start is with the very first ETF: the Standard & Poor’s Depositary Receipt, or SPDR.
A Breakthrough Idea
The Standard & Poor’s Depositary Receipt, better known as the SPDR, launched on the American Stock Exchange in 1993. The idea behind the world’s first major ETF was simple: Package together all the stocks in a familiar market index and allow traders to buy and sell that package as a single unit. The SPDR tracked the performance of the S&P 500 Index through full replication, holding all 500 stocks in that index.
The appeal was and is obvious: Investors or traders who want to buy or sell “the market” no longer need to buy each stock in the index, with the related brokerage fees, custodial hassles, rebalancing, shifting spreads, etc. Instead, they can make just one trade and gain instant access to the entire basket.
The initial audience for the SPDR consisted of traders, institutions and other professional users. The uses were varied. Institutional investors and hedge funds realized that a stock that tracked an entire index had great potential as a hedging instrument. Mutual fund portfolio managers discovered they could eliminate cash drag by buying ETFs to “monetize” their cash positions intraday. As options linked to the ETF emerged, sophisticated traders found new ways to manage risk in a portfolio.
Over time, however, the audience for this “trader’s product” broadened to include retail investors, and financial advisors focused on long-term asset allocation. It is this “retail” investor class that has driven much of the recent growth in the market.
Indexing Evolved
One reason ETFs became popular with retail investors was coincidental: Their debut in the 1990s coincided with a wave of interest in index-based strategies. Although the first index mutual fund launched in the 1970s, it was only during and after the Technology bubble of the late 1990s that investors turned to indexing en masse. According to John Bogle, the founder of the Vanguard Group, in 1990, there were barely $1 billion in total assets in all equity index mutual funds. By 2004, that had soared to more than $550 billion, or one-sixth of all equity fund assets.
Indexing’s key advantage is efficiency. Indexing is a passive investing style, because like the index, the fund’s components don’t change often, and changes occur from predictable, transparent rules. With less portfolio turnover than an actively managed fund, the fund incurs fewer transaction and management costs. Without pools of fundamental analysts making decisions on individual stocks, ETF providers can charge commensurately less for their services.
According to Morgan Stanley, the average expense ratio for a U.S. equity index fund is 0.70%. But the average actively managed U.S. equity funds charged 1.45% a year, and more for non-U.S. equities.
ETFs take indexing’s core advantage and amplify it. The average equity ETF charges just 0.53%, and on an asset-weighted basis, that figure drops further. ETFs are able to deliver this larger cost advantage because they externalize many of the costs of running a conventional mutual fund.
Changing The Way Investors Invest
While the structural advantages of ETFs set the stage for the product’s growth simply as a tool, it is likely that ETFs have actually changed the way retail investors approach investing itself, if for no other reason than the number of options available to them has increased.
In the past, investors and advisors focused much of their energy on absolute performance. However, because of the ETF revolution, many investors (and their financial advisors) have adopted core-and-satellite asset allocation strategies. While individual managers with active, alpha-generating strategies are still used, they are selected for their specific expertise, not simply because they provide exposure to a particular asset class. Increasingly, the job of alpha generation has shifted from the traditional active mutual fund manager toward the advisor, who is ever-more careful in making asset allocation recommendations, and selecting active managers.
This is the way that large institutions and endowments have managed money for decades, blending portfolios of different equity styles, countries, sectors, bonds, commodities and currencies to achieve the maximum risk-adjusted returns, with additional alpha added from individual, carefully screened active managers.
The breadth of ETFs in the market has made this shift toward generating returns at the asset allocation level both easy to implement and economically feasible for individual investors and advisors for the first time. By providing focused, targeted access to individual asset classes, and by opening up new markets like commodities, currencies and international fixed income to retail investors for the first time, ETFs have improved asset allocation strategies, lowered costs and reduced barriers to entry. Individual investors can now invest like the smartest, largest institutions in the world … and they are increasingly doing so.
4 Barclays Global Investors
5 Investment Company Institute
6 Barclays Global Investors