ETFs: Past, Present, and Future

Bradley Kay
Associate Director, European ETF Research

Ben Johnson
ETF Strategist, European ETF Research

March 25th , 2010

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 Overview

 A Very Brief History

 The ETF Marketplace Today

 What Is An ETF?

 What Advantages Do ETFs Offer?

 Trends For The Future

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 Whence We Came: ETF Market
Evolution

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 A Very Brief History
 1990 – The SEC issued the Investment Company Act Release No. 17809. This would
ultimately facilitate the creation of mutual funds that were able to create and
redeem shares intraday.

 1993 – SPDRs S&P 500 begins trading on the AMEX in January.

 1999 – The Tracker Fund of Hong Kong (TraHK) was launched in November,
becoming the first ETF in Asia.

 2000 – In April, the European Exchange Traded Fund Company launched a pair of
listed diversified return securities (LDRS) on the Deutsche Borse. The funds, which
tracked the EURO STOXX 50 and STOXX 50 indices were co-managed by Merrill
Lynch. Later in the same month, iShares launched the first ETF in the UK, the iFTSE
100.

 2003 – In February the first ETF on a fixed-income index in Europe was launched.
The ETF eb.rexx Government Germany was issued by Indexchange and tracked the
Eurex Bonds Government Germany index (eb.rexx).

 2003 – ETF Securities launches the world’s first exchange-traded commodity Gold
Bullion Securities in Australia and London.
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 European ETF Asset Growth by Broad Asset
Category
£175

£150

£125
ETF Assets (GBP Billion)

£100

£75

£50

£25

£0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 J an-10

EquityAssets Fixed Income Assets CommodityAssets

Source: Blackrock, Bloomberg

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 Where We Are Now

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 Proliferation of Asset Classes

Category/Asset Class # of ETFs Total Net Assets As a % of Total Industry Assets

Europe Equity 424 60,526,666,986 42.47

International Equity 243 32,723,777,179 22.96
Fixed Income 153 30,582,153,845 21.46
Traditional Asset 820 £123,832,598,0 84.68
Classes 10

Commodity 291 16,982,675,211 11.92

Other 18 1,476,473,085 1.04
Currency 22 208,379,461 0.15
European ETF 1151 £142,500,125,7 100.00
Industry Total 66
Morningstar Data as of Feb. 2010

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 Proliferation of Asset Classes
 In the beginning, ETFs only offered broad index
and equity sector exposure

 Now, ETFs offer access to nearly every asset

category imaginable
Fixed Income
Fundamental Indexes
Commodities
Currencies
Leveraged Equity
Hedge Fund Strategies
Niche Sector Slicing

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 What Is An ETF?
 An umbrella term, covering a broad array of legal
structures with a proliferation of abbreviations
 ETFs × ETNs
 ETCs × ETPs

 Defining attributes
 Tracks a specific index or a strictly-defined
portfolio of securities
× Almost exclusively passive investments
 Traded on a stock exchange
× A retail investment vehicle by nature
 Short-term arbitrage opportunity via daily or
weekly share creations/redemptions
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 What Is An ETF?
 Typically UCITS III compliant
 Diversified portfolios of securities: stocks, bonds,
derivatives

 Physical-replication ETFs
 Match their index by holding the actual securities in a
unique trust
 Full or Sampled replication

 Synthetic-replication (or swap-based) ETFs

 Obtain their index exposure through OTC swap
contracts
 Hold securities in their own trust and/or have
collateral pledged to mitigate counterparty risk
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 What Is An ETC?

 Formerly “Exchange-Traded Commodity”, now also currency funds

 Typically does not meet diversification standards for UCITS III

 Single commodity funds
 Single currency funds

 Debt instruments issued by Special Purpose Vehicles (SPVs)

 Degree of counterparty risk varies widely

 European Union Prospectus Directive allows broad distribution

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 What Is An ETC?
 Physically-backed
 Only precious metals
 Virtually zero counterparty risk

 Synthetic-replication
 SPV sometimes keeps the ETC’s capital, but usually
given to total return swap (TRS) counterparty
 Collateral may be allocated through a third-party
custodian or simply pledged by the TRS counterparty
 Acceptable securities for collateral can vary widely
from provider to provider
 Read Those Prospectuses!

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 What Is An ETN?
 Exchange-Traded Note

 Debt instrument issued by a backing bank

 Senior, unsecured debt of that bank
 Substantial counterparty risk!

 Not a very popular vehicle in Europe, with only two

issuers
 Lyxor pledges collateral for their ETNs
 Barclays Capital issues uncollateralized ETNs

 Much more popular in the U.S., where they have

substantial tax advantages for futures-dependent indices
such as commodities
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 Innovation, You Say?

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 What’s So Great About ETFs?

 Incredibly low costs

 Intra-day liquidity and real-time trading

 Access to new asset classes and strategies

ETFs bring the institutional to the

individual

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 Low Costs
 Passive investments
 No expensive analysts
 Typically low turnover

 Numerous back-office and mid-office efficiencies for

providers
 Only need to issue and redeem shares with a limited
number of market makers
 Shifts portfolio trading costs to ultra-efficient market
makers or swap counterparties

 Custodial costs have economies of scale due to cross-

listings and broad distribution pulling in assets from
across Europe
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 Intra-Day Liquidity and Real-Time Trading
 Real-time execution means that you know the price you are
paying

 Can provide more liquid exposure to illiquid asset classes

 When corporate bond markets froze in 2008/2009, credit
bond ETFs kept trading

 Market makers arbitrage away premiums and discounts,

keeping prices close to fair value

 Warning: This shifts the onus of ensuring fair execution onto

the final buyer rather than the provider
 Liquidity differs from fund to fund

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 Access to New Asset Classes & Strategies

 Funds for in-house use with sophisticated clients are

now easily offered to retail investors as well
 Physical precious metals
 Asset allocation strategies
 “Alternative betas”

 ETFs serve as a wrapper for futures contracts that

would otherwise have too high of a minimum size for
retail investors

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 Where Do We Go From Here

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 Expansion of the Retail Market

 Everyone in the industry is waiting for the retail market

to appear, but it will be harder than expected

 Four major preconditions to a robust retail ETF market

in Europe
 Increased retail investor demand
 Greater trading volume / visible liquidity
 Greater transparency
 Simple cross-border transactions within EU

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 Expansion of the Retail Market: Investor
Demand

 Need to make the case to individual investors for low

cost and passive investment
 Who will be the UK’s Jack Bogle?

 A critical mass of advisers and other financial

professionals looking for low cost vehicles
 Organic movement toward fee-based financial
advice took decades in the US
 Regulatory pushes in Europe may accelerate the
process
(UK’s Retail Distribution Review)

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 Expansion of the Retail Market: Greater
Trading Volume
 OTC trading volume does not do much for retail investors

 Need to recruit a new sort of institutional investor, as heavy

exchange traders and retail investors have a natural symbiosis in
ETFs
 Make shorting ETFs easier
 Movement toward ETFs as cheaper, easier, and more flexible
than other forms of beta exposure (futures, swaps, etc.)

 Moving trade volume onto the exchanges is a self-perpetuating

process once it starts, as greater liquidity makes larger on-
exchange trades easier, which in turn generates more liquidity

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 Expansion of the Retail Market: Greater
Transparency
 Apply MiFID to exchange-traded funds
 Reveal all liquidity to all market participants
 Help retail investors feel comfortable that the playing field is level

 Retail investors want to know what they are holding

 Full portfolios published frequently and with little delay

 Synthetic replication ETF providers will have to win not just on cost and
on tracking, but also have to match the openness
 Make collateral rules easier to find
 Disclose collateral portfolios as well as index portfolios
 This information is already available to institutional investors

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 Expansion of the Retail Market: Cross-Border
Transactions

 Liquidity makes ETFs a winner-takes-all competition

 Institutions will trade across borders for the best execution
 Retail investors need to be able to do the same
 This trend is already coming to fruition, as several retail brokerages offer fairly
inexpensive trading throughout the EU

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 Consolidation in the European ETF
Marketplace

 This winner-takes-all competition for liquidity will drive consolidation

in the ETF marketplace
 One or two “winners” will take the vast bulk of assets and trading
volume for any given index to track
 Despite having lower assets and not much growth, many smaller
funds will remain alive on assets from in-house customers

 Off-exchange distribution channels can not drive this consolidation

 Liquidity and low trading costs are the draw of the top funds, and
they do not carry over to off-exchange distribution

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 Product Innovation Will Continue

 New entrants in a more mature market can only

compete on low costs or product innovation

 Plenty of new areas ripe for expansion

 Fundamentally-weighted indices
 Screened indices
 Active ETFs
 Funds of hedge funds
 “Alternative beta”

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