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ETF Analyst Roundtable: 2011 And 2012

Olivier Ludwig

 

Quite a lot happened in the world of exchange-traded funds in 2011, not the least that assets kept rolling into ETFs, even as uncertainty surrounding the global economy remained just as acute as it was when markets collapsed in 2008.

ETFs raked in almost $121.5 billion this year through Dec. 29, and total assets in U.S-listed ETFs are up almost 5 percent to more $1.058 trillion. That number includes market movement, which is saying a lot about the growing popularity of ETFs, considering the S'P 500 Index was unchanged this year.

The Senate hearing in Washington, D.C. in October on the dangers of ETFs has to be near the top of anybody’s list of top ETF stories this year—simply because it was a clear suggestion that ETFs are reaching critical mass and about to enter the public consciousness in a big way.

What follows is a virtual roundtable of our in-house talent sharing their views. Each opinion, in its own way, reflects IndexUniverse’s perspective as one of the more important independent voices of news and data specifically focused on ETFs.

Enjoy the insights, and, on behalf of all of us at IndexUniverse, may you all have a happy and prosperous new year.

 

Matt Hougan, President of ETF Analytics; Global Head of Editorial, IndexUniverse:

There are lots of choices for the biggest ETF story of 2011, from the regulatory inquiries, to the HOLDRS acquisition, to the growth of international fixed income, to Pimco's Total Return ETF filing. It’s been quite a year.

But I'm going to go outside the usual for my top story choice and pick the Vanguard Total Bond Market ETF (NYSEArca:BND - News) passing the iShares Barclays Aggregate Bond Fund (NYSEArca:AGG - News) as the largest bond ETF by assets . On the one hand, it's a random data point; on the other hand, it speaks to a major trend, which is the commoditization of the "pure beta" section of the ETF industry.

The ETF industry seems to be dividing in two.

On the one hand you have simple, market-cap-weighted beta exposure, where there’s a race to the bottom in fees, and investors are willing to switch products to save a few basis points. That’s partly why you see Vanguard growing so quickly, and firms like Schwab and others starting to gain share as well.

On the other hand, you have a new and dizzying array of complex strategy ETFs that charge high fees to execute institutional-style strategies—funds like the Barclays S'P Veqtor ETN (NYSEArca:VQT - News), which rotates between S'P 500 exposure, short-term VIX futures exposure and cash, and which somehow has gathered $100 million in assets.

I think this is a trend that’s here to stay, with a group of extraordinarily low-fee ETFs competing for beta exposure, and a group of high-fee funds competing (essentially) against active mutual funds.  The resulting fee wars can only be good for investors.

As for 2012, I the biggest headline of the year is:"ETF Assets Jump 30 Percent."

I think ETFs are closing in on critical mass, and that we are setting the stage for a massive growth in assets.

More mainline fund companies are lining up to enter the ETF space; firms like Pimco and Vanguard are getting increasingly serious about ETFs; and advisors as well as retail investors are just starting to "get" ETFs, to the point where they are becoming the default choice ahead of single stocks, mutual funds or closed-end funds.

If we get any sort of reasonable growth in the markets, I think 2012 could see a significant jump in ETF assets, probably the largest dollar jump in the history of the industry.

 

Elisabeth Kashner,  Senior Vice President of Analytics, IndexUniverse:

This year was about the man who cried wolf, the wolf at the gate and the cost of protection.

There are plenty of risks lingering in ETFs, and it’s too bad the Kauffman Foundation’s Harold Bradley’s ill-prepared Senate testimony on ETF risks pointed to nonexistent threats, because we could use some well-crafted regulation. Europeans had a better time of it, with well-deserved regulatory attention to counterparty risk that made us all pay more attention to issues like settlement risk, securities lending and failure to deliver.

ETF issuers responded to last year’s concerns by bringing out several contango-management commodities funds as well as volatility-tracking products. Too bad the volatility trackers don’t really track volatility! With a fund count of 1,370 and over $1 trillion in AUM, ETFs had another year of stellar growth.

What should we look for in 2012? Maybe some continued mergers and acquisitions action, like we saw with Market Vectors’ acquisition of best-of-breed HOLDRS. Maybe we’ll see further forays into alternatives, which grew like a weed this year. Or maybe 2012 will be the year of consolidation, as issuers conclude that market saturation and competition on fees makes rationalization and specialization attractive. And don’t forget the Securities and Exchange Commission. Will anyone look to ETFs for fresh campaigning material?

 


 

Gene Koyfman, ETF Analyst, IndexUniverse:

Over the past year, the biggest story has been the continued rally in Treasurys and the U.S. dollar, even after Standard ' Poor’s downgraded U.S. long-term debt in August.

Despite concerns of the increasing U.S. debt burden and a federal government incapable of compromise—all in the context of a weak recovery—investors have piled into these two assets at the slightest hint of uncertainty, largely from the deeply troubled eurozone.

Indeed, the dollar and Treasurys trade doesn’t look like a vote of confidence in the United States, but rather, a big statement about a lack of confidence in anything else.  Even after the S'P downgrade, investors continued to seek the perceived “safety” of the dollar and Treasurys. This has flown in the face of most rational analysis focused on the U.S. domestic situation.

The rally burned the likes of Bill Gross, who, at the beginning of the year, was adamant that Treasurys would collapse and interest rates had nowhere to go but up.

The other variable in this equation has been the Federal Reserve, which is deeply committed to keeping rates low to stimulate the economy. Everyone was waiting for inflationary pressure related to that loose monetary policy to rear its ugly head, but those fears didn’t materialize in 2011.

Largely due to the bad state of affairs in Europe, yields on Treasurys are at record lows, yet many people are hesitant to take what may appear as the obvious trade, namely shorting Treasurys. The reason remains simple:Until the European mess has some semblance of an end in sight, people will continue to be hesitant to take on excess risk, and always be at the ready to rush to the “safety” of the United States.

That means that, for now, 2012 looks like it will be all about finding ways for investors to avoid Europe.

One of these investments may well be U.S. equities. As the recovery in the United States continues to gain traction, investors will likely turn to U.S. stocks in an effort to get ahead of what appears to be an inevitable increase in inflation and benefit from the improvements in the overall economy.

U.S. businesses appear to have taken steps to streamline leaner in their operations during the downturn, with corporate profits for the most part exceeding expectation and growing steadily.  For those who don’t think the Fed will renege on its commitment to keep rates near zero until 2013, corporate bonds—both investment grade and high yield—may be an attractive source of yield. This is an alternate play on the improved health of corporate America.

 

Cory Banks, Managing Editor, Exchange-Traded Fund Report:

The biggest ETF story of 2011 was the U.S. Congress taking serious notice of ETFs. Investors were spooked by huge volatility swings this summer, and it seemed like many wanted to finger-point for a reason. As much as Harold Bradley and others at the Kauffman Foundation wanted it to be true, ETFs were not—and are not—the problem. The congressional hearings also brought up some interesting propositions, like Noel Archard's push for product relabeling. I may not agree, but having those kinds of discussions in such a theater is good for the industry as a whole.

Another important story this year was that, even though we're all trained to be wary of leveraged and inverse ETFs, investors are clearly using them. Look at the flows for geared ETFs for 2011, and you’ll see the big positive inflows for these asset classes. It looks to me that not only are investors figuring out these "complex" products, they're using them to express specific opinions on the market. That's encouraging—it's time for average investors to stop being afraid of ETFs and stop viewing them as "advanced" vehicles.

As for 2012, I’m terrible at prognosticating. But I think you'll see an increase in more interesting products coming to market. We're more or less past the idea of a one-size-fits-all fund idea. The more issuers can build specific exposures for their products, the better. I actually found myself excited about the Global X Social Media ETF (NYSEArca:SOCL - News ) once it launched. If products come out that can predict what investors are going to be interested in next, that's good for everyone.

 


 

Ugo Egbunike, ETF Analyst, IndexUniverse:

Undoubtedly, the biggest story of the year was Europe and the euro, as the European Union argued and fought over measures to save the monetary union and the currency. Many ETFs tumbled, including the iShares MSCI Switzerland Index Fund (NYSEArca:EWL - News), which took a hit after the Swiss National Bank pegged the franc to the euro as a means of bringing down the rally in the franc.

Debt issues weren’t unique to Europe, as U.S. debt was downgraded by Standard and Poor’s. Fortunately for the U.S. government, the market completely ignored the downgrade, as funds like the iShares Barclays 20+ Yr Treasury Bond ETF (NYSEArca:TLT - News) outperformed the S'P 500, with double-digit returns.

We also saw international ETFs enter the spotlight and become the main points of price discovery. Consider the Market Vectors Egypt ETF (NYSEArca:EGPT - News ), which continued to trade throughout the Arab Spring uprising in the Middle East—even though creations were suspended. Also, think of the iShares MSCI Japan Index Fund (NYSEArca:EWJ - News), which became a focal point for investors in the aftermath of the Japanese disaster in March.

On a corporate level, McGraw-Hill rocked the index world when it announced that S'P and Dow Jones would come together under one umbrella—a move that not only brought together the most widely used benchmarks in the world—the S'P 500 Index and the Dow Jones industrial average—but also meant that a significant amount of ETF assets would be tracking one index family.

In trading, we saw two major stories as memories of the “flash crash” were revisited with the “pricing error” behind a newly launched group of Focus Shares funds. Months after, UBS trader Kweku Adeboli lost $2 billion in ETF delta-one trading—a move many thought was unimaginable.

The attacks on ETFs stemming from the rogue trading incident to leveraged and inverse ETFs led to a congressional hearing on ETFs that proved to be one of the first majorly publicized efforts of regulators paying close attention to ETFs. They didn’t settle much, but they met, which was significant.

Despite the negative press and extra attention paid toward ETFs, BlackRock’s iShares received SEC approval for a line of active ETFs —a big move in the industry for such a dominant firm.

Looking ahead to 2012, one of the biggest developments may be the launch of more active ETF funds with new twists and specialties. In 2011, we saw the SPDR Gold Shares (NYSEArca:GLD - News) physical bullion ETF, become the largest ETF in the world for a few moments . But in 2012, I think we may be a step closer to the end in the gold rally, as prominent fund managers continue to exit their positions in the precious metal.

 

Carolyn Hill, ETF Analyst, IndexUniverse:

One of the biggest ETF stories of 2011 had to be the closure of the Egyptian stock market, and subsequent halt in EGPT creations for nearly two months after Egyptians revolted and forced the ouster of former president Hosni Mubarak.

Besides the obvious impact the revolt had on neighboring Arab countries and ensuing market turmoil, it also highlighted a major function of ETFs—price discovery. Even though Market Vectors halted creations on EGPT, the fund continued trading, allowing investors to place bets on Egypt even while its exchange was closed. It also served as a reminder of why we like the creation/redemption process so much, as the suspended creation process caused EGPT to hit huge premiums.

In the next 12 months, I’m interested to see how ETF issuers respond to the European debt crisis, as well as when money will start flowing back into European funds. Another interesting potential development I’m curious about is whether Congress will act at all to restrict investment in risky ETFs, such as levered and inverse or futures-based funds.

 


 

Dennis Hudachek, ETF Analyst, IndexUniverse:

Biggest ETF Stories For 2011

Vanguard funds surpassing EEM and AGG:I think BND surpassing AGG, and the Vanguard MSCI Emerging Markets ETF (NYSEArca:VWO - News) surpassing the iShares MSCI Emerging Markets Index Fund (NYSEArca:EEM - News), is more significant than just two big funds being eclipsed by even bigger ones. Vanguard is really breathing down iShares’ neck as investors turn toward the significantly lower costs of many Vanguard funds.

HOLDRS:The liquidation of most of these securities that have been obsolete for years, and the transition of the top six HOLDRS into Market Vectors ETFs governed by the Investment Company Act of 1940 is also one of 2011’s big stories. HOLDRS were equities with no weighting caps, because they were grantor trusts. So now there are no more grantor trust equity funds; only open-end funds and unit investment trusts are left.

Dividend ETFs:The massive inflows and frenzy over dividend ETFs was also big last year. Investors piled into them looking for yield in a zero-interest rate environment and to own companies with strong balance sheets at a time of uncertainty surrounding Europe’s debt crisis.

International Bond Funds:The successful launches of international bond funds, most priced in local currencies, was a big trend last year, too. Investors dove into these funds, such as the WisdomTree Asia Local Debt Fund (NYSEArca:ALD - News), looking for attractive yields and exposure to currency appreciation against the dollar.

Top ETF Stories For 2012

Leveraged/Inverse Funds:I expect continued scrutiny and criticism of these types of funds, especially because many more are in the pipeline. Direxion has a slew of triple-exposure funds in filings, and ProShares has many leveraged funds in filing as well.

ETFs in 401(k)s:Following Schwab, ETFs in 401(k)s will probably continue to gain traction. There may be friction with regulators, as some, notably the Kauffman Foundation, warn of ETF risks. The articulation of such concerns may start a huge debate regarding whether ETFs are safe and appropriate for 401(k)s, compared to mutual funds.

Proliferation of Active ETFs:Active ETFs are gaining traction, and just as mutual funds took over the money management industry, active funds may have a significant future in the ETF world. I think it’ll be huge when Pimco launches the ETF version of the Total Return Fund, the largest bond fund in the world.

Fund Closures:I expect more fund closures as the ETF space gets saturated and crowded.

Niche ETFs:I also expect more issuers coming out with niche funds. Probably frontier market funds will make a huge splash. There will be many funds for obscure markets, like Nigeria, Kazakhstan, UAE, Qatar, Indonesia small-caps, etc. Every possible niche you can think of, someone will probably launch.

MSCI Reclassification of South Korea as a Developed Market:I'm  thinking ahead of what that will do in terms of weight rebalances to ETFs like the iShares MSCI Emerging Markets Index Fund (NYSEArca:EEM - News) and the Vanguard MSCI Emerging Markets ETF (NYSEArca:VWO - News). It will affect weights in MSCI EAFE funds as well.

 


 

Paul Britt, ETF Analyst, IndexUniverse:

To me, 2011 was less about any specific event and more about the theme "the bloom is off the ETF rose." The Kaufman Foundation report, Andrew Ross Sorkin’s critique of ETFs in the New York Times and others cast ETFs as dangerous—not just for investors but for capital markets as a whole.

ETFs were blamed variously for:

  • Volatility in capital markets, especially intraday volatility caused by geared funds
  • Increased correlations
  • Impairing capital formation, i.e., keeping small firms from raising money in the capital markets

 

Bullet No. 1 is false, disproved by IndexUniverse Director of Research Dave Nadig , as well as by Credit Suisse. Bullet No. 2 has some truth to it, but ETFs are only a small part. Impact from mutual funds and other forms of index investing is far greater. Bullet No. 3 is just plain false.

Looking ahead to 2012, I wonder:

  • If bitter debate among issuers in Europe will spill over into the United States
  • Whether debate on naming and especially  limiting access for certain types of funds will gain any momentum
  • How new HOLDRS-cum Van Eck ETFs will fare
  • How next-generation “contango killers” in futures-based ETFs will perform
  • What will happen in a eurozone meltdown scenario—especially for eurozone underwriters of U.S.-listed ETNs

 

 

Paul Baiocchi, ETF Analyst, IndexUniverse:

Quite possibly the biggest ETF story in 2011 was the shuttering and restructuring of the HOLDRs funds.

Not all of the funds were popular, but the six that became Van Eck ETFs had $3.65 billion in assets as of Aug. 12, when the announcement of the exchange offer came out. In fact, the 11 HOLDRs that were discontinued altogether had over $460 million in AUM at the time of the announcement, showing that these funds were popular despite often-snide remarks made about them.

In many ways, the closure of these funds represents an end of the age of ETF innocence, as the HOLDRS were perhaps the final link to a now bygone era of ETF infancy, and we may look back on this news as a landmark day in the still-burgeoning expansion of the ETF industry.

As for 2012, will this be the year where active ETFs finally gain traction and further eat into the assets of major mutual funds in this country? Will we see major legislation passed to curb the access of amateur investors to leveraged and inverse products?

Will the rehypothecation concerns surrounding gold bullion ETFs bubble over? Will issuers continue the trend of self-indexing? Will the convergence of 401(k)s and ETFs continue full mast?

I can’t wait to find out.

 

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