Six ETF Stories From The First Six Months Of 2010

by on July 2, 2010 | ETFs Mentioned:

The incredible rise of the ETF industry has been one of the biggest stories in the investment space over the last few years. The emergence of these securities as a favorite tool of both buy-and-holders and active traders has transformed the investing landscape, bringing indexing strategies to the forefront and bringing increased scrutiny to the concept of active management.

The first six months of 2010 saw the continued evolution of the ETF industry. In addition to the launch of dozens of new products, entrance of a handful of new issuers, and tweaks to existing funds, the first half of the year took several unexpected twists and turns that could have a lasting impact on the competitive landscape of the ETF industry and change the manner in which investors construct their portfolios. As the calendars turn to July, we take a stroll down memory lane to revisit some of the most important developments in the ETF space from the first six months of the year.

1. Price Wars Escalate

For several years, Vanguard has been known within the ETF industry as the low cost issuer, offering up funds that generally feature the lowest expense ratios in town. But late last year Charles Schwab, another firm known for its focus on minimizing investor expenses, waded into the ETF waters. Looking to make a splash, Schwab rolled out a broad-based U.S. Equity ETF (SCHB) that claimed the title of cheapest ETF of the market [see more fundamentals of SCHB here]. Vanguard then promptly reduced expenses on VTI at the beginning of the year in order to make VTI the cheapest on the market. Schwab responded in June by slashing expenses on six of its funds, making each of them the cheapest in their respective ETFdb Categories [see Schwab Declares ETF Price War].

It’s tough to tell where this development will lead. Most of the shots fires in the ETF price wars have come from Schwab and Vanguard. But others are getting in on the act too. Old Mutual cut expenses on its emerging market ETF temporarily, and Van Eck recently reduced fee caps on three of its popular international equity ETFs as well. If investors gravitate towards the cheapest ETF options, expect further expense ratio cuts from other issuers.

2. SEC Reviews Use Of Derivatives

One of the biggest stories of 2009 was the controversy surrounding leveraged ETFs; investors failed to grasp the objectives and underlying mechanisms of these products, leading to misconceptions about how these funds would perform in volatile environments. The fallout from those events continued in the first half of 2010, when the SEC announced that it was evaluating the use of derivatives by mutual funds and ETFs. “It’s appropriate to engage in a more thorough review of the use of derivatives by ETFs and mutual funds given the questions surrounding the risks associated with the derivative instruments underlying many funds,” said SEC Chairman Mary Schapiro in a press release.

The exact scope of the SEC review isn’t certain, and neither is the timing. But the impact on the ETF industry has already been felt. The closer scrutiny on these products has prompted several firms, including Claymore and AdvisorShares to file amendments to existing funds that eliminated the potential to use derivatives in their strategies.

No one in the ETF industry is sure what the exact outcome of the review will be; the repercussions could be relatively minor or could dramatically change the manner in which leveraged and active ETFs are managed and promoted. Stay tuned–this could be one of the biggest stories of the second half of the year as well [also read Hancock Plans "Derivative-Free' Active ETF].

3. Flash Crash

When markets went haywire on May 6, bizarre stories began to emerge even before the closing bell had rung. Tales of trades in multi-billion dollar companies being executed for fractions of pennies made headlines, leading to rampant speculation on Wall Street as to what went wrong. But as the day went on, it became apparent that ETFs had been disproportionately impacted by the “flash crash.” Figures compiled in the following days showed that approximately 70% of trades canceled were ETFs. Moreover, it wasn’t only small, thinly-traded funds that showed nonsensical prices; several of the largest U.S.-listed ETFs temporarily became nearly-worthless, with some changing hands for only a penny [see Ten Shocking ETF Charts From The Flash Crash].

The research into the exact causes of the “flash crash” is ongoing, and the exact reasons for the ETF bias in the canceled trades remains somewhat unclear. That one day in May will likely have a lasting impact on the ETF industry. Whether it is a positive or negative one remains to be seen.

4. Active ETF Anticipation

At this time a year ago, many in the industry were predicting that actively-managed ETFs would be the “next big thing,” gradually eating into the market share of traditional mutual funds. PIMCO and WisdomTree have seen impressive success with a handful of their active products, but on the whole the active ETF space has been slow to gain traction.

The first half of the year saw some interesting developments in the active ETF space, indicating that despite the slow start, the outlook for this corner of the market may be extremely bright. Several big players in the asset management business have been busy laying the groundwork for a foray into the ETF industry; Legg Mason joined the likes of T. Rowe Price, JP Morgan, and Eaton Vance around the periphery of the ETF industry, preparing to make a run at the space sometime soon.

Another major development in the active ETF space came near the end of the quarter, when Grail Advisors announced a partnership with DoubleLine, the firm founded by fixed income whiz Jeffrey Gundlach. That marriage set the stage for the active ETF industry to add its first superstar manager, a development some predict will lead to significant interest and cash inflows. After anticipation built in the first two quarters, it figures to be an eventful second half of the year for active ETFs [also see Actively-Managed ETFs: Could The Floodgates Be Opening?].

5. Vanguard Ups The Ante

Vanguard has been steadily gaining ground in the ETF industry, luring investors into its funds with the lowest expense ratios in the business. Some in the industry think its only a matter of time before Vanguard claims the top spot on the ETF totem pole, thanks to its reputation as a low cost provider and its patent on the structure that allows it to create an ETF share class of its existing mutual funds.

Another late-quarter development has intensified the competition between Vanguard and rival iShares, which currently accounts for about 50% of ETF assets. Vanguard announced plans to roll out ETFs linked to several well-known indexes, many of which are already covered by existing iShares products. Again, it will be interesting to see how this saga plays out in the second half of the year and throughout 2011; if Vanguard is able to eat into iShares’ assets, it could mark a tipping point in the ETF industry [see Race For Cheapest ETFs Heats Up].

6. Commodity Boom Continues

A closer look at the drivers of the surge in ETF assets in recent years may surprise some investors. The biggest cash inflows haven’t been to equity funds, but to products offering exposure to commodity prices. The introduction of the exchange-traded structure has brought exposure to to natural resources within reach of more investors than ever before, and many have embraced ETFs as a way to add diversifying agent to traditional stock-and-bond portfolios.

This boom has continued in the first half of 2011; through May commodity ETPs had taken in more than $5 billion, accounting for the vast majority of total industry inflows. Innovation in the commodity space has kept pace with the impressive inflows. The first six months of the year saw the launch of commodity products offering pure play exposure to platinum, palladium, corn, and Brent oil, among others. And several SEC filings offered up some details on what the next generation of commodity ETFs might look like: ETF Securities has outlined plans for commodity products that may feature improved tax efficiency, while USCF may roll out a quasi-active commodity fund [see Next Generation Of Commodity ETFs].

If the second half of 2010 is anything like the first, the ETF industry is in for more excitement, further expansion, and perhaps a few surprises. Stay up to date with all the changes in the industry with our free ETF newsletter.

Disclosure: No positions at time of writing.