The market for exchange-traded funds exploded in 2000, up to nearly $76 billion by year end from about $39 billion the previous year, an increase of 82%. In the fourth quarter alone, $25 billion flowed into ETFs, and industry sources expect the market to reach $500 billion in the next four to five years.
The number of ETFs has swollen to 80 from 30 a year ago, and only a handful two years ago. Cash flow has grown just as quickly. For all of 1999, cash flow into ETFs was about $14 billion, nearly double that of 1998. Interest has grown to such an extent that ETFs accounted for more than two-thirds of the daily trading volume on the American Stock Exchange, according to a report last year by Strategic Insight Mutual Fund Research and Consulting LLC, New York. Institutional investors control at least half of ETF shares, according to Strategic Insight
Each of the three major ETF sponsors - The Bank of New York Co. Inc., New York; Barclays Global Investors, San Francisco; and State Street Global Advisors, Boston - has seen interest in these securities accelerate in the past year. Pensions & Investments' survey of index fund managers included for the first time a question on ETFs. The survey found that State Street was the largest ETF manager, with $34.5 billion under management at the end of 2000; followed by Bank of New York, with $29 billion in ETFs; and BGI, with $12 billion. During 2000, BGI attracted more than $10 billion into its ETFs, according to the P&I survey. State Street attracted $9.3 billion in new business, followed by Bank of New York with $5 billion.
Trade like stocks
Exchange-traded funds are useful to institutional investors as hedging vehicles, and as a means of equitizing cash or maintaining market exposure during transitions from one money manager to another or from one market sector to another. An ETF is a passively managed basket of stocks that mirrors a particular index and that can be traded like ordinary shares. They trade intraday on stock exchanges, like securities, at market-determined prices. In essence, ETFs are index funds that trade like stocks. About 80% of ETFs trade on the Amex because it offers real-time pricing of ETF securities. However, the New York Stock Exchange is gearing up its ETF capabilities.
The seemingly overnight success of ETFs is widely attributable to the marketing and promotion efforts by BGI, which sponsors a total of 66 ETFs - 60 in the United States, three in Canada and three in the United Kingdom. BGI launched 41 ETFs last year and already has introduced two in 2001.
According to Gavin Quill, an analyst at Financial Research Corp., New York, "Barclays' massive product development effort has transformed the ETF landscape by creating alternatives in just about every investment category necessary to complete a robust asset allocation model."
According to officials at BGI, ETFs are a suitable alternative for institutions that are not permitted to use futures, because ETFs can be sold short on a downtick. Their liquidity and intraday trading characteristics make ETFs useful to hedge fund managers, who can set a hedge for minutes, days or months, said Lee Kranefuss, chief executive officer-individual investor and ETF products at BGI.
"Institutions such as money managers and mutual funds use them to equitize cash," he said, investing cash in an ETF representing a particular market segment to maintain market exposure. "They are very flexible products which can be used in a variety of ways."
As an example, he said, a pension fund moving from an active to a passive small-cap manager or from one active manager to another usually buys a basket of stocks, creating potentially a large number of trades. But one trade in the BGI iShares Russell 2000 ETF keeps the cash invested in a security that tracks the relevant benchmark without the cost and complexity of a basket trade, while remaining fully invested, he said.
The largest ETF is State Street's SPDR - which tracks the Standard & Poor's 500 stock index - at more than $25 billion. This was the first ETF, launched in 1993.
State Street introduced 11 ETFs last year - 10 domestic and one in Canada - and expects to launch 14 ETFs in Europe by April. "Pension systems (in Europe) are starting to liberalize now, and that will be good for both ETFs and mutual funds," said Greg Ehret, principal at State Street. Another potential hot spot for ETFs is Australia, he said, where the investment market "is more similar to the United States than is Europe, where you sometimes experience a lot of regulation and obstacles."
"ETFs are a way to get overall market participation; they are funds that trade like stocks," said Mr. Ehret. "If you want to participate in the S&P 500 or the Nasdaq 100, or any number of other indexes, it's a good way to do it. ETFs don't have the back-office operations that mutual funds do. They can be good long-term investments because most are structured as index funds right now, and the fees and expenses are cost effective."
To illustrate just how fast ETFs have grown, the cash inflow of more than $26 billion last year into both Bank of New York's QQQ, which tracks the tech-heavy Nasdaq 100 index, and its S&P 400 Midcap SPDR would have placed second among mutual fund families for net cash inflows. BNY would have finished just behind Janus Capital Corp., Denver, which had cash inflows of $37 billion, and ahead of mutual fund giants like the Vanguard Group; Putnam Investments Inc. and INVESCO. That's not bad for a security that was largely unknown 18 months ago, and it happened during one of the worst periods ever for domestic stock markets.
Joseph Keenan, vice president and global product manager of exchange-traded products at Bank of New York, said about 30% of BNY's ETF shares outstanding are owned by institutions such as money managers, hedge funds and mutual fund portfolio managers. Portfolio managers sometimes use ETFs as an arbitrage tool, assessing the value of the ETF against underlying securities and either buying or selling to take advantage of price mismatches, he said.
Mutual funds untouched
Although ETFs often are viewed as substitutes for index mutual funds, Mr. Keenan said the securities have not siphoned assets from traditional mutual funds. "We haven't seen any direct cannibalization. ETFs have grown up along with mutual funds," he said. "ETFs may be capturing some of the new money flows, but as far as drawing money out of mutual funds, we haven't seen any of that. There is a lot of brand loyalty in the fund business."
Merrill Lynch & Co., New York, has a related security that resembles an ETF. Its HOLDRs are concentrated baskets of stocks selected by Merrill from a specific industry. They are not ETFs because they do not track an index. HOLDRs attracted about $1.4 billion in new cash flows last year.
More ETFs are in the pipeline from firms such as Valley Forge, Pa.-based Vanguard, which has filed for SEC approval of a series of ETFs to be called VIPERS. In addition, Nuveen Investments, a division of John Nuveen & Co., Chicago, has issued six municipal-bond ETFs and has filed for an ETF called Nuveen America's Fastest Growing Companies index.
The success of ETFs might expand globally. In February, officials of the Amex and the pan-European stock market Euronext announced an agreement in principal to create an ETF joint venture to provide a vehicle for European investors to trade Amex-listed ETFs. U.S. investors would be allowed to trade Euronext-listed ETFs. Amex officials signed a similar agreement last June to launch an ETF-based venture with the Singapore Exchange.
Despite the growing awareness of ETFs by individuals and institutions, there are some who question the long-term viability of the hybrid security. Of the 80 ETFs on the market, more than half of the assets are in three ETFs - Bank of New York's QQQ and S&P 400 Midcap SPDR, and State Street's S&P 500 SPDR.
That concentration is of concern to some in the financial community.
"It's true, the market for ETFs has taken off," said Mark Riepe, vice president and manager at the Schwab Center for Investment Research, San Francisco. "Or, is it that SPDRs and QQQs have taken off. A couple of products have been very successful, but it is a stretch to say the whole market has taken off. It doesn't seem to have rubbed off on other ETFs to date."
Mr. Riepe acknowledged the growing visibility of ETFs in the past year but added, "How long are they going to be around and will there be a role for the rest of them (beyond SPDRs and QQQs), that's hard to say."
A report issued by Schwab in January, co-written by Mr. Riepe, also pointed out "the net asset values and trading volumes of (ETFs) portend liquidity concerns. There are days when no shares, or only a very small number of shares, will trade for some of the funds. As more of these funds are offered with overlapping objectives, these liquidity concerns could increase, as market participants gravitate toward the product with the most trading activity."
"The tracking-error statistics suggest that over the relatively short interval of observations, the ability of ETF shares to track the underlying asset value is quite good," the Schwab report said. However, "these observations are based on a relatively stable period in the market."