Five Bold Predictions For The ETF Industry

by on June 7, 2010 | ETFs Mentioned:

Predicting the future of an industry that has consistently exceeded expectations is obviously challenging. Even two years ago, few could have forecast the increase in number of exchange-traded products to nearly 1,000, nor the impressive rise to nearly $1 trillion in assets. The tremendous success of commodity and fixed income ETFs came as a surprise to even those within the industry, while the slow start for actively-managed ETFs has been equally perplexing. Throw in an increasingly uncertain regulatory environment, and predicting the future of the ETF industry becomes a fool’s errand.

The next few years will be interesting times for the rapidly-expanding ETF space, no doubt filled with more than a few twists and turns. Below, we step out on a limb to make five bold predictions for the next five years in ETFs (for more on the ETF industry, sign up for our free ETF newsletter):

5. MacroShares Will Be Redeemed

Over the last several years, more than a dozen companies have ventured into the ETF industry, aiming to capture a piece of a booming market. None of these new entrants are threats to overtake iShares, but most of them have experienced a fair amount of success and achieved “proof of concept;” sector-specific emerging markets, hedge fund strategies, and revenue-weighted products are just a few examples of funds that have carved out a niche in the ETF industry.

But there have also been some colossal failures. HealthShares launched a line of hypertargeted biotech ETFs, including the Metabolic-Endocrine Disorders Fund and Autoimmune-Inflammation Fund, that are almost comical in hindsight (see all the funds profiled in the ETF Hall Of Shame). And MacroShares made three separate attempts to introduce pairs of exchange-traded products that offered exposure to oil and home prices. The MacroShares model was definitely unique; an “up fund” and “down fund” pledged to deliver assets to one another based on the movement in an underlying reference index (e.g., crude oil prices).

To say that there were a few kinks in these products would be like saying that the Titanic sprung a leak. But the underlying concept has a ton of potential; it’s potentially a better (i.e., contango-free) mousetrap for offering commodity exposure, and could theoretically allow investors to bet on or hedge against fluctuations in a limitless number of economic indicators (unemployment rate and inflation, just to name two).

We’d be willing to bet that somewhere behind-the-scenes, an ETF issuer is hard at work on a new and improved version of the “paired ETF” concept. And when they bring it to market, don’t be surprised if it becomes a smash hit.

4. GLD Will Overtake SPY

Launched in 1993, the S&P 500 SPDR (SPY) was the first ETF available to U.S. investors, and for years has been the largest by total assets. That first distinction is obviously safe in perpetuity, and many believe the second is as well; with assets just north of $70 billion at the end of May, SPY is about $21 billion ahead of the closest challenger, the Gold SPDR (GLD).

Our second bold prediction is that GLD will close that gap, and eventually overtake SPY to become the largest U.S.-listed ETF by total assets. The argument for such a scenario is two-fold. First, there are currently a number of major financial institutions gathered around the periphery of the ETF industry. When the T. Rowe Prices and Legg Masons of the world finally jump into ETFs, expect their product lineups to include funds that fall into the Large Cap Blend ETFdb Category, competing either directly or indirectly with SPY. None of these newcomers will ever get close to the assets of SPY, but their aggregate presence will add up.

Second, GLD is much earlier in its life cycle than SPY. Commodity exposure through ETFs is still a relatively young concept, and growth in the next couple years figures to be strong. Over the last year, GLD’s assets have grown by more then 40%, compared to only about 12% for SPY (despite a big jump in per share value). If those trends continue, GLD would overtake the top spot in less than two years.

3. Wave Of Closures Ahead

As a whole, the last few years have been very good to the ETF industry. But the surge in assets that has thrust exchange-traded products into the forefront of the investing landscape has not been distributed evenly among all participants. About half of all ETF assets are found in 20 tickers, with the remaining 50% spread across the other 975 or so funds. There are 331 ETFs with less than $25 million in assets, and more than 450 fall below the $50 million threshold–the rule-of-thumb breakeven point in the industry.

Many of the ETFs in this category are new products just hitting the sweet spot on their growth curve, and will probably blow through the $50 million mark before the year is up. But many have been around for years, and if they haven’t gained sufficient traction yet, they probably never will. New product launches should continue at a good rate in coming years. But the pace of closures will accelerate tremendously. Of the nearly 1,000 exchange-traded products currently available, expect at least 10% of them to be extinct by the end of 2011.

2. Number Of Issuers Skyrockets

The big four of the ETF industry–iShares, State Street, Vanguard, and PowerShares–currently account for more than 85% of total assets. And that’s not likely to change any time soon. But over the last several years, the number of companies sponsoring exchange-traded products has surged, and many of the newcomers have seen a great deal of early success. Based on a review of regulatory filings, as well as discussions with executives at ETF issuers, we expect the number of active ETF issuers to surge from about 30 currently to more than 60 within the next three years.

This wave of newcomers will be made up of two distinct groups. Established financial institutions that have so far missed out on the ETF boom are preparing to play catch up, hoping that a late entrance to the game will be better than continuing to watch from the sidelines as mutual fund assets are slowly eroded by changing investor preferences. Second, smaller players will continue to pop up with niche products not currently available in ETF form. As the impressive start of the Silver Miners ETF (SIL) has shown, there are still good ideas out there to be uncovered.

More issuers will, more than likely, be a positive development for investors; increased competition will force increased efficiency and lower costs.

1. Vanguard Cuts Into iShares’ Lead

As the ETF industry has boomed, no issuer has benefited quite as much as iShares. As one of the early movers in the space, the San Francisco-based firm has seen assets swell as investors have made the switch to ETFs. Even as the number of issuers has grown, iShares has managed to maintain close to 50% market share, an impressive show of strength in an increasingly competitive industry.

But there are chinks in the armor. EEM, iShares’ largest product by assets, has seen the competing Vanguard fund (VWO, which also tracks the MSCI Emerging Markets Index) gain significant ground. Over the last year, Vanguard has seen its market share increase from 10% to 13%, thanks in large part to its reputation as a low cost provider and a broad trend towards minimizing fees (see Five Ways To Slash Your ETF Expenses). With only about a quarter of the assets of iShares, it’s too far-fetched to imagine that Vanguard will someday overtake the top spot in the industry (particularly considering the impressive early success of iShares recent additions to its product line).

But it’s not unreasonable that they could cut into the lead, achieving 25% market share–roughly double the current level–within the next five years. If expenses matter as much as some studies seem to indicate, Vanguard could see its piece of the pie grow in coming years.

Disclosure: No positions at time of writing.