New strategies expected to feed ETF surge in ’05

As 2005 approaches, the $211 billion exchange-traded fund industry is toasting to a new year of increased product expansion. Yet it might be premature to raise a glass to the actively managed ETF.

From established providers such as Barclays Global Investors, San Francisco, to feisty, younger companies such as PowerShares Capital Management, Wheaton, Ill., fund companies are busy laying the groundwork for new ETF products. Speculation about fresh ETF flavors and strategies reached a fever pitch after the first U.S. ETF that tracks the price of gold, State Street Global Advisors' streetTRACKS Gold Shares, began trading in mid-November.

Among other new ETF ideas being kicked around the industry are ones based on more precious metals, as well as other commodities. Some of the more far-reaching ETF ideas focus on areas such as corporate governance.

"ETFs are very in vogue right now," said David Haywood, director of alternative investment research at Financial Research Corp., Boston. "New types of commodity products like oil may present opportunities. There's a lot of talk."

The American Stock Exchange, a pioneer in ETF creation, continues to break new ground. It has been working on an active ETF design and hopes to "get some product created around that solution … if not by the end of 2005, not much thereafter," said Clifford J. Weber, senior vice president of the ETF marketplace. The concept, however, has not been registered with the Securities and Exchange Commission, he said.

Unlike traditional ETFs, actively managed ETFs are not linked to an index, making them less transparent. Yet it is unclear how an actively managed ETF would disclose its portfolio holdings, since active managers would be highly reluctant to share their trades for fear that someone might try to trade against them.

Until those issues are worked out, Wall Street will greet a second gold ETF — from Barclays Global Investors — in early 2005. BGI, whose iShares ETF family has $107 billion in assets, also plans to launch an ETF based on a socially responsible index toward the beginning of next year, and is evaluating one based on a broad-based commodity index, said J. Parsons, managing director of intermediary business.

When it comes to new offerings, providers are keeping the specifics close to the vest. Executives at most fund companies contacted by Pensions & Investments emphasized that they are exploring options and focused on adding products around their current lineup as competition heats up.

"A lot of those will be ‘me-too' products, so (providers) are not necessarily filling in holes, but trying to get a position at the table," Mr. Parsons said. "We (at BGI) see 82% of all flows into ETFs in the U.S. That's a fairly dominant position that leads people to believe they ought to get a share of that. I welcome the competition."

Still, the question is "how do we complete sets that we have?" Mr. Parsons said. "In the U.S., (BGI has) 97 products, six of which are fixed income. That seems a disproportionate balance. One goal is to broaden our fixed-income offerings."

Noel Archard, product manager at The Vanguard Group, Valley Forge, Pa., said he also sees opportunities for expanding upon the firm's existing 20 ETFs, known as Vanguard Index Participation Equity Receipts, or VIPERs. Mr. Archard said Vanguard is looking to launch a VIPER on its European portfolio, tracking the MSCI Europe benchmark. It is also planning a VIPER on its Pacific Fund, tracking the MSCI Pacific benchmark, and a VIPER on its emerging market portfolio, linked to the MSCI Select benchmark.

Since entering the ETF universe in 2001, Vanguard has grown its business significantly. VIPERs have a total $5.7 billion in assets as of early December, up from $2.6 billion at the end of 2003, Mr. Archard said. Growth will be strategic. "It makes sense to put new VIPER shares against (MSCI) portfolios," he said.

As far as broader applications go, it is likely that more ETFs will be wrapped into products geared toward retail and high-net-worth investors, said Gus Fleites, senior principal at State Street Global Advisors, Boston, with nearly $80 billion in ETF assets. He also said ETFs could find other creative uses as part of tax-managed programs, helping to minimize a client's tax impact.

"That's where you will see innovation … in packaging products," Mr. Fleites said.

Advances in the marketplace are also coming from some lesser-known companies. PowerShares is muscling its way into the industry with plans to roll out 24 ETFs over the next several months. That's on top of two brought to market earlier this month — one investing in an index of U.S. companies that draw most of their revenue from China, and the other hitched to a benchmark of dividend-paying stocks.

The company's other two ETFs, the Dynamic Market Portfolio and the Dynamic OTC Portfolio, were introduced in May 2003. A total of about $335 million is invested in PowerShares' four ETFs. Most of its client base is made up of brokers and advisers, but it is starting to receive more calls from institutions, said Bruce Bond, chief executive officer.

"A year and a half ago, when we launched our first funds, no one had heard of PowerShares. Today, advisers are aware of their value," Mr. Bond said.

PowerShares are based on enhanced indexes that seek to provide "market outperformance or exposure to unique market segments," Bond said.

Some of the PowerShares are based on the company's "Intellidex" methodology, developed by AMEX, which identifies the stocks with the greatest investment merit and then selects the top issues for the index.

Six of its 24 new ETFs will be based on the Style Intellidex indexes, Mr. Bond said. The other funds are based on indexes created by ValueLine, New York City, and Zacks Investment Research, Chicago, as well as WilderShares LLC, San Diego.

The remainder will comprise industry and sector-type products, which will also be based on new Intellidex indexes consisting of the 30 stocks with the greatest investment merit within each market segment. PowerShares registered all of the offerings with the SEC in July.

"These have all been in registration for a little while, and we are seeing tremendous interest from sophisticated advisors, so our first move is to get these out and move forward," Mr. Bond said.

Yet before newly proposed ETFs are released to the public, they face significant regulatory hurdles. There are a number of technical challenges to overcome in structuring the product, such as pricing issues. And for every technical challenge, there usually is an equivalent regulatory obstacle.

Both the issuer and the exchange file with the SEC. Historically, the approval process has been lengthy. It took more than 28 months for Financial Research's Standard & Poor's Depositary Receipt to receive a green light, according to FRC. The application was initially filed in June 1990, and it was amended four times; the order was finally granted on Oct. 26, 1992. iShares waited a little more than a year for approval.

"The SEC takes that obligation seriously," Vanguard's Mr. Archard said.

"If you want to launch a large-cap growth ETF, that's pretty clean. If you start taking on a more difficult flavor … you have to prove that this makes sense as an investment and represents what it will do."

That means an actively managed ETF will likely have to overcome a host of obstacles to gain approval, both from a technical and policy standpoint.

Going forward, "a flood of new products really depends on (a provider's) ability and the SEC's ability to streamline the process," Mr. Parsons said.