Four Revelations About The ETF Industry

by on September 21, 2010

As the ETF industry has evolved over the last several years, it has seen its share of both ups and downs. Recent years have seen a tremendous surge in ETF assets, as well as the number of funds and number of firms offering exchange-traded products–a testament to the popularity of this vehicle with advisors, institutional investors, and individuals. But there have also been some speed bumps along the way, including dozens of funds that have closed down due to lack of investor interest, controversies around some of the more complex ETPs out there, and the chaos of the recent “Flash Crash.”

Last week, Morningstar held its first ever all-ETF conference in downtown Chicago, bringing together an impressive list of executives from around the world. The focus of the event was educating financial advisors on the many uses and potential pitfalls of using ETFs in client accounts, but the gathering of many of the industry’s biggest players also provided an opportunity to gain some insight on the future direction of the industry. Below, we highlight four somewhat surprising revelations to come out of the event, shedding some light on what coming months and years may hold for the ETF industry [see Five Bold Predictions For The ETF Industry]:

SEC Reviews Dragging On

In discussing plans to roll out new products and continue to grab ETF market share, several issuers commented on a noticeable extension in the regulatory approval process, especially for funds that would maintain the ability to use derivatives if they so choose. By some accounts, the amount of time required to obtain the required approvals has more than doubled, a development attributable primarily to increased scrutiny from regulatory agencies.

In the wake of the most recent financial crisis, efforts to enhance consumer protections should generally be applauded. But the tremendous amount of scrutiny being placed on proposed ETFs has complicated the operations of many issuers considerably, and is currently depriving the market of some very intriguing products [see Three Active ETF Gamechangers].

Leveraged ETFs Still Getting A Bad Rap

One of the biggest stories in the ETF industry in 2009 focused on the performances of leveraged ETFs during a period of unprecedented market volatility; due to the daily rebalancing, most leveraged ETF products performed very poorly during extended periods of time. That created a great deal of confusion surrounding the intended uses and nuances of leveraged ETFs, and uninformed reporting on the matter led many investors to incorrectly conclude that leveraged ETFs didn’t perform as they should have.

Thanks in part to education campaigns launched by ETF issuers, it seemed that many of the misconceptions surrounding leveraged ETFs had long since been cleared up. But unfortunately, that may not be the case. It was a little depressing to hear some prominent members of the media demonstrating their ignorance on the topic, resolute in the belief that leveraged ETFs are flawed products that don’t perform how they should over multi-session holding periods.

There’s still some misinformation out there related to what these products are and aren’t supposed to do. Hopefully it doesn’t spread any further than it already has [see Clarifying Seven Misconceptions About Leveraged ETFs].

Productive Flash Crash Follow-Up

Another speed bump for the ETF industry came in May, when almost 70% of the trades canceled in the wake of the “Flash Crash” were ETFs. With details slow to emerge on the exact cause of the sudden market meltdown, some investors began to worry that ETFs had played a part the day’s tumultuous event. A number of ETF executives shared that the events of May 6 were frightening for the industry, but expressed confidence that ETFs were victims of the “Flash Crash,” and not the cause of the sudden plunge and subsequent recovery.

A panel made up of execs from many of the biggest ETF issuers pointed out that the implementation of “circuit breakers” on ETFs was a big step in the right direction, noting that the industry came together many times in recent months to discuss steps necessary to ensure the investing public maintains confidence in the efficiency of ETFs [see Ten Shocking ETF Charts From The Flash Crash].

Product Development Boom To Continue

With more than 1,000 exchange-traded products now available to U.S. investors, some have expressed an opinion that the ETF industry has reached a point of saturation–basically that all the good ideas have now been taken. Citing a number of recent fund closure announcements, we’ve been hearing that the industry may be due for a major slowdown on the product development frons and a period of contraction. Don’t buy a word of it. Based on discussions with folks from dozens of ETF sponsors, the pipeline continues to fill with all sorts of interesting ideas, including twists on existing products and completely new ideas not currently available in ETF form [see New ETFs Grow Up Fast].

We’re not convinced that all of the ideas we heard tossed out will ultimately prove to be successful, but for the most part they seemed to have been designed with the goal of delivering exposure investors want but don’t currently have access to through an ETF. Expect the pace of expansion to remain strong throughout 2010 and into next year, as existing issuers continue to expand their product lineups.

[For more ETF insights, sign up for our free ETF newsletter]

Disclosure: No positions at time of writing.