ETF Industry Pauses: Summer Slowdown Or Saturation?

Published on by on September 1, 2011

The growth of the ETF industry over the last several years has been truly impressive, both in terms of asset increases and expansion of the product lineup. ETFs have moved quickly from a small closet industry to the investing mainstream, becoming an increasingly formidable challenger to mutual funds that have long been the dominant vehicle for investors seeking to build a long-term portfolio. ETFs have, of course, become popular with demographics beyond just the long-term, buy-and-hold investors for whom they were originally designed. Many exchange-traded products are used primarily by those who measure holding periods in seconds and minutes as opposed to years; the huge turnover in some funds is evidence that more active traders have found ETFs to be extremely useful as well.

Regardless of the audience or objectives, the industry has expanded rapidly, as a surge in the number of new products has opened up new investment strategies and asset classes to investors. The drivers behind this growth are rather straightforward and obvious. ETFs provide a low-cost, transparent structure for individuals and institutions to gain access to a wide range of asset classes. The unrivaled liquidity and enhanced tax efficiencies are icing on the cake, further enhancing the value add of a structure that until a few years ago was relatively unknown.

ETF Saturation?

There are now nearly 1,300 ETFs with aggregate assets of more than $1 trillion. Both of those numbers have climbed steadily higher in recent years as issuers have debuted new products and cash inflows into ETFs have remained relatively strong–though perhaps a bit volatile. While many of the new products offer exposure to “plain vanilla” asset classes, new ETFs have undeniably become more specialized in nature. Recent additions to the lineup have been increasingly granular in nature, offering targeted exposure to narrow sub-sectors or nuanced investment strategies. Whereas the “first generations” of ETFs were blunt tools to achieve broad-based exposure, the second wave of growth has been driven by precise instruments for fine tuning portfolios.

This specialization, for some reason, has been a source of frustration to some. Perhaps viewing hyper-targeted ETFs as a threat to the original purpose of ETFs–vehicles for building cost-efficient long-term portfolios–some in the industry have railed against the innovations in the sector that have pushed the number of products gradually higher.

Throughout the past two years, product launches have been fast and furious; dozens of issuers have rolled out an impressive number of first-to-market funds. But during the past few months, the pace of new ETF product launches has slowed a bit. That has left some wondering if the ETF industry is just experiencing a summer slowdown, or if a saturation point is finally nearing. Judging from our ETF Launch Center, the past two months in particular, have seen few products hit the market. During the final two weeks of August, not a single new ETF debuted.

So are we finally reaching a saturation point where all the good ideas have been covered and no stone has been left unturned? Or is the industry simply going through a summer slowdown that will precede an active fourth quarter of the year? An examination of both past trends and the current pipeline of proposed products suggests the latter. To give us a better idea of how 2011 has fared for ETFs, we compare the number of launches this year to 2010:

As shown above, 2011 started off quite strong; the year has already seen 211 launches up through the end of August–an average of more than one new ETF per trading day. Over the same period in 2010, only launched 152 new ETFs had launched. Bear in mind that in all of 2010, 230 ETFs hit the market, meaning that 2011 will likely surpass that figure before the year’s end. With such a solid start to the year, the last few months have been nothing short of disappointing, but it doesn’t necessarily point to a slowdown [see also Van Eck Plans European High Yield Debt ETF].

It’s worth noting that last year saw a similar slowdown during the summer months when trading activity tends to decline. Though the past month has been a notable exception, August is generally a slow period for financial markets; with much of Wall Street headed to the shore, trading volumes tend to drop quite a bit. That makes it a less-than-optimal time to launch new exchange-traded products, which often rely on strong market receptions to get an initial boost. Low trading volumes out of the gate can create an uphill battle for ETTs, since many investors still mistakenly presume a link between average daily volumes and the true liquidity of a product.

Next, consider the thousands and thousands of mutual funds that currently exist on the market; with just 1,300 ETPs, it seems that the industry is just getting started, as there are numerous options that the space has yet to explore. Instead, the low growth in the past few months is likely attributable to the summer seasonality.

New Products Gaining Ground

New ETFs
Ticker Name Launch AUM*
ALD Asia Local Debt Fund 3/17/2011 $647.8
VXUS Total International Stock ETF 1/27/2011 $303.3
HDV High Dividend Equity Fund 3/29/2011 $275.5
SPLV S&P 500 Low Volatility Portfolio 5/5/2011 $235.5
WDTI Managed Futures Strategy Fund 1/5/2011 $229.1
* In millions. As of 8/31

The impressive debuts of some recently-launched products lends some credibility to the idea that there is still plenty of room for expansion. The First Trust Cloud Computing ETF (SKYY), perhaps the poster child for niche ETFs, has already grown to more than $50 million in just a few short months (SKYY debuted in early July). The Global X Fertilizers/Potash ETF (SOIL), another niche ETF that attracted a fair amount of skepticism when launching, has surpassed $30 million in assets since debuting in May.

These niche ETFs obviously aren’t for everyone. In fact, the vast majority of investors probably have little to no use for funds like SKYY or SOIL. But the cash flows into these funds clearly shows that there is some interest, and perhaps gives issuers the proof of concept to continue development of more targeted products.

While the pace of new product launches may have slowed, the growth of the funds that have debuted in 2011 demonstrates quite clearly that some stones remain unturned. The 211 new ETPs that debuted through the end of August have aggregate assets of about $4.2 billion (an average of around $19 million per ETF). Not too shabby for funds that have only entered the investing realm in the last few months, especially considering that many institutions and investors refuse to buy into products without a track record of a certain period of time–sometimes as long as three to five years.

As far as the 2011 launches are concerned there are a few funds that stand out as investor favorites: Vanguard’s Total International Stock ETF (VXUS), which offers broad-based exposure to international equities, has raked in nearly $300 million so far. The WisdomTree Asia Local Debt Fund (ALD) has been another huge success; that ETF, which offers exposure to debt of developed and emerging Asian economies that is denominated in local currencies, has amassed over $620 million. The S&P 500 Low Volatility Portfolio (SPLV) from PowerShares, which tracks the lowest volatility stocks on the S&P 500, has already grown to more than $220 million in assets.

Looking Down The Pipeline

While the pace of new product launches may have slowed a bit, issuers remain generally active on the product development front. The amount of filings has stayed relatively constant as we keep the ETF pipeline full of new ideas to corner various aspects of different markets. Despite the wide range of new products being detailed, there are a few clear trends emerging. International bonds seems to be a space of intense activity, as issuers race to deliver products offering exposure to an often overlooked but increasingly important segment of the global bond market.

With ALD’s impressive growth as exhibit A-1, it seems reasonable to expect that international bond ETFs will account for significant portions of ETF growth going forward. At least five different issuers have filed details on proposed China bond ETFs, though there remain significant hurdles to bringing such a fund to market (the extremely limited liquidity of many Chinese debt securities is perhaps the biggest issue to address). Other filings in recent weeks have sketched out funds offering exposure to debt from fiscally sound developed economies such as Australia and Germany.

Another popular trend has come from sector ETFs both for U.S. and international market spaces. Global X recently filed for a number of hyper-targeted sector funds including what could be the first ever railroad ETF. Other issuers have chosen to delve in emerging market segments, allowing as much targeted exposure to economies like India and Brazil as one could find here in the U.S.

Another area that seems ready for expansion is alternatives, an asset class that investors and financial advisors are recognizing as an important component of long-term portfolios but that is a relatively young and small segment of the ETF market.

Sources in the ETF industry tell us to expect an extremely active September and continued expansion throughout the fourth quarter of the year. Don’t let the slow pace of July and August fool you; there are plenty more ETFs coming, and the record for new product launches will be shattered before 2011 draws to a close.

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