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  • Appendix A: Understanding ETFs
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The Opportunity Landscape

New entrants to the ETF market face challenges far different from those encountered by the industry’s early pioneers.

Over the past year, companies have created ETFs for asset classes previously difficult for the small investor to reach. ProShares, with its leveraged and short ETFs, opened up new markets and trading styles to the average investor, and has accumulated more than $20 billion in assets. Newcomer Direxion, which also offers leveraged ETFs, garnered $80 million in assets in its first month of trading.

In 2009, at least 10 new ETF companies are waiting in the wings, lining up products for launch despite challenging market conditions.

In Europe, the markets are at an earlier point in their growth. The first ETF didn’t launch in Europe until 2000. Although internationally listed exchange-traded products tend to target a slightly different audience—they are more often the province of traders and institutions than independent financial advisors—the situation is evolving rapidly. In an effort to increase the level of consumer trust, the U.K.’s Financial Services Authority is seeking to raise professional standards, improve clarity on independent advice and sales advice, and reduce conflicts of interest. These and other new regulatory proposals in the United Kingdom would, if approved, significantly increase the use of ETFs by independent financial advisors.

Outside of the U.S. and European markets, the market for ETFs is younger still. Some countries with established exchanges and established mutual fund industries do not yet have ETFs, although history suggests that demand would emerge if they were launched. In other markets, investors may have access to one or two funds, but nothing like the depth and breadth of funds they need to create and implement a successful asset allocation strategy.

Looking Ahead

The rise of ETFs has indeed been a revolution for investors. However, it would be a mistake to think that the market is mature. New entrants—especially those with established distribution channels, brand and marketing savvy—will no doubt emerge, and be successful. “One size fits all” has never worked in the investment management industry, and there’s no reason to suspect it will with ETFs either. ETFs and traditional mutual funds are different distribution mechanisms for investment products—different pathways to an ultimate goal of investment returns. There are applications where mutual funds may be the logical choice, and applications where ETFs make more sense.

What is clear, however, is that the surge in ETF assets is not a flash in the pan, but rather, a once-in-a-generation breakthrough that is reshaping the way investors invest. ETFs will continue to gain assets, and will continue to gain a greater share of assets, as more and more investors discover the transparency, liquidity, flexibility and low costs they provide.

For companies seeking to enter the ETF market, the window is still open. Opportunities remain for companies that are nimble and can attack quickly and smartly. New fund sponsors have options in their approach: build vs. buy, solo vs. partners, active vs. passive. These options all have their pros and cons.

What is certain is this: With ETF assets under management expected to top $2 trillion within three years, the business opportunity is large, and the revolution is far from over.