Future Of The ETF Industry: Part I

by on November 16, 2009 | ETFs Mentioned:

According to the National Stock Exchange, total cash flows into exchange-traded products through the first ten months of the year have totaled more than $72 billion, an indication that the ETF industry continues to grow by leaps and bounds. While this figure is down slightly from the same period in 2008, it is widely expected that the ETF space will continue to expand, transitioning from a closet industry to a mainstream investment vehicle embraced by buy-and-holders and short-term traders alike.

Global ETFs Could Be The Next Big Growth DriverWhile the future is undoubtedly bright, the specifics are a bit cloudy. Some anticipate a wave of consolidation, both among funds and issuers, while others expect the number of funds to double (or even triple) as the big banks and asset managers watching from the sidelines (such as Schwab) finally join the fray.

Many industry insiders have pointed to actively-managed ETFs as the next area of growth in the industry, but this space has been slow to develop. The Dent Tactical ETF (DENT) has less than $25 million in assets, while the five PowerShares actively-managed funds have accumulated less than $30 million and Grail Advisors has less than $15 million in its five actively-managed ETFs.

There have been several other innovations in the ETF space that bring significant potential for future growth. OOK Advisors recently launched two state-specific ETFs, while several issuers have introduced Shariah-compliant ETFs designed to conform with Islamic religious law. These ETF niches obviously bring tremendous potential, but so far have been slow to attract investor assets, indicating that they are unlikely to “go mainstream” and make a significant dent in total assets.

We are bullish on the future of the ETF industry, but think that future growth will come from more traditional areas that are, for the most part, being overlooked. This week, ETF Database is taking a look towards the future, making our predictions for what the future holds for the ETF industry (to get the complete series delivered to your inbox, sign up for our free ETF newsletter).

Back To Basics

The first wave of ETF products, led by the now ancient SPY, were primarily “core” products, ETFs focusing on major asset classes (such as small, mid, and large cap equities). Once that “land grab” was complete, issuers began focusing on niche markets, structuring ETFs focusing on increasingly narrow segments of the domestic and global economy (the ill-fated HealthShares ETFs took this to the extreme, offering about 20 ETFs investing in various corners of the health care space).

But we’re now seeing that the product development pendulum is swinging back. The most successful new ETF launches in recent memory (excluding perhaps many of the leveraged ETFs that have immediately become smash hits) have been the Silver Trust (SIVR) and Physical Swiss Gold Shares (SGOL) from ETF Securities. While these products do differentiate themselves in a few minor ways, they are, all things considered, rather simple products, offering exposure to spot prices of gold bullion and silver. Three months after launch, SIVR has a market capitalization of $150 million, while SGOL has assets of more than $250 million about two months after inception. We think the success of these products (as well as the early results for DJCI) indicates that the ETF market, including the market for “core” products, is far from saturated.

Beyond The “Home Country Bias”

Historically, U.S. investors have allocated the bulk of their portfolios to domestic securities, based on the perception that foreign equities are overly risky. But over the last few years, many investors in U.S. equities have suffered significant losses and endured extreme volatility, as the “risk gap” between domestic equities and emerging markets (real or perceived) has closed.

The “home country bias” of many U.S. investors remains strong, but there is evidence that is beginning to fade. Traditional long U.S. equity ETFs have seen assets increase from about $286 million in October 2008 to $317 million in October 2009, an increase of 11%. Over the same period, assets in long international ETFs has increased by almost 85%. Domestic equity ETFs have actually seen cash outflows in 2009 of more than $30 billion, while global and international equity ETFs have taken in almost $25 billion.

Some investors have swung completely to the other side, avoiding exposure to U.S. equities completely when constructing portfolios. ETFdb Pro members can see an example of this investment strategy in our Ex-U.S. Model ETF Portfolio (if you’re not a Pro member yet, you can sign up for a free trial or read more here).

As the ETF industry has expanded, investors have seen their options for exposure to U.S. markets multiply. Those looking to invest in stocks of a specific size, style, or sector have multiple funds from which to choose. For investors looking to invest in the financials sector, there are 25 funds in our Financials ETFdb Category. Those looking for energy exposure have even more options – there are 34 ETFs in the Energy ETFdb Category, most of them invested primarily or exclusively in U.S. companies.

Country Equity ETFs GDP (Trillions USD) Ratio
U.S. 397 $14.4 27.6
Japan 11 $4.9 2.2
China 8 $4.3 1.9
Germany 1 $3.7 0.3
France 1 $2.9 0.3
Source: ETFdb ETF Screener

But options beyond the U.S. remain surprisingly limited. Most international ETFs are broad-based funds that invest in all sectors of their respective economy. Investors bullish on the telecom sector in China or the financial sector in Brazil have no way to make this play without also gaining exposure to consumer goods companies and utilities stocks. According to our ETF Screener, there are almost 400 ETFs offering exposure to the world’s largest economy (the U.S.), nearly 20 times the number investing in the second through fifth largest (Japan, China, Germany, and France).

Given the obvious interest for international investments, either as a core allocation in portfolios or as a complementary holding, this imbalance seems likely to be remedied.

Already Underway

New York-based Emerging Global Advisors (EGA) has been the pioneer in this space, launching three emerging markets ETFs targeting the financials (EFN), metals & mining (EMT), and energy (EEO) sectors (as well as a composite emerging markets fund). EGA is also planning several additional sector-specific emerging markets ETFs (including consumer goods, health care, telecom, and utilities products), as well as infrastructure ETFs investing exclusively in China, Brazil, and India.

Another ETF issuer, Global X, is not far behind, filing for approval on a series of sector-specific China ETFs, including consumer goods and services, energy, financials, industrials, materials, and technology. At present, the China Equities ETFdb Category includes primarily funds focusing on mega cap companies across a variety of sectors, as well as a small cap (HAO) and all cap (YAO) ETF.

The potential for this segment of the ETF industry is huge. As U.S. investors continue to embrace global equities, demand for targeted exposure to foreign markets should increase substantially. It isn’t too far-fetched that in two years time we could see dozens of sector-specific ETFs focusing on each of a dozen developed and emerging markets outside the U.S.

Disclosure: No positions at time of writing.