THE BOOM IN EXCHANGE-TRADED FUNDS IS reshaping the investment landscape by challenging traditional mutual funds and giving investors, large and small, the opportunity to get exposure to virtually every major market and asset class in the world—and many minor ones as well.
ETFs are passive mutual funds and trusts that trade like stocks on major exchanges; they can be bought or sold anytime during the trading day. They held a record $940 billion of assets in the U.S. on Oct. 31, up from $794 billion at year-end 2009, and are on track to hit $1 trillion around the end of 2010.
Net inflows totaled $89 billion in the first 10 months of the year, as investors poured money into ETFs focused on developing-market stocks, bonds and precious metals. Exchange-traded funds are gaining market share at the expense of traditional mutual funds, which (excluding money-market funds) hold about $8 trillion of assets.
The benefits of exchange-traded funds include low fees, relative to mutual funds, transparency of investments and tax efficiency because of low portfolio turnover. These funds provide exposure to specific indexes, like the Standard & Poor's 500 or Russell 2000, as well as such investments as gold, natural gas, junk bonds, inflation-protected Treasuries and master limited partnerships. "A lot of investors are realizing the benefits of diversification, and ETFs allow broad diversification at low cost," says Gus Sauter, chief investment officer at Vanguard. It's understandable that investors favor broader portfolios because a U.S-focused equity strategy hasn't done well in the past 10 years, in which the S&P 500 has essentially been flat. As global economic power shifts away from developed markets, investors want exposure to rising countries like China, India and Brazil.
Active traders are heavily involved with exchange-traded funds. Many day traders now play ETFs, including volatile ones that move by double and triple the daily change in their underlying indexes. Popular day-trading vehicles include the Direxion Daily Financial Bull 3x Shares (FAS) and Direxion Daily Financial Bear 3x Shares (FAZ) that offer triple leverage and triple inverse leverage to the financial component of the Russell 1000 index.
The ETF business is highly concentrated, with the 10 largest funds—out of a universe of about 1,000—accounting for 40% of all assets and three just issuers, BlackRock's (BLK) iShares, State Street Global Advisors and Vanguard, controlling 82% of industry assets. Trading in ETFs averages $62 billion a day and accounts for about 25% of the volume on U.S. exchanges.
ETFS ARE A GREAT democratizing force. With a click of a mouse, individuals can get access to stocks in virtually every corner of the world and to assets like commodities that can be cumbersome to buy and largely have been limited to institutions.
Try purchasing 100,000 ounces of silver and then finding a safe place to store it. But it's relatively easy to purchase 100,000 shares of the iShares Silver Trust (SLV, each of whose shares equals one ounce of the metal), which has attracted $9 billion since its introduction in 2006. The largest commodity ETF, the SPDR Gold Trust (GLD), now holds $60 billion of the metal in London vaults. Its popularity has played a role in gold's 25% rise this year, to $1,365 an ounce.
A Booming Sector
More than 1,000 exchange-traded funds exist, covering everything from emerging-market stocks to energy to U.S. blue chips and Treasury bonds. Through October, ETFs pulled in a net $89 billion in assets this year.
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Each GLD share, now at $134, equals 1/10th of an ounce of gold, minus a management fee of 0.40% a year. That modest fee has been well worth paying, given the doubling in gold's price since 2008.
Critics say that an influx of ETF money may be contributing to a bubble in some commodities like silver, which has jumped 20%, to $26 an ounce, since Sept. 30.
Investors have been focusing on commodities and other hard assets to play growing demand in the developing world and amid fear that the Federal Reserve's controversial plan to print money via the purchase of $600 billion of U.S. Treasury securities over the coming months will debase the dollar and spur inflation. Cotton has doubled in price since midsummer and a new cotton exchange-traded note, the iPath Dow Jones-UBS Cotton (BAL) is up by a similar amount.
Many real users of commodities contend that investment demand has distorted markets. Gold jewelry demand, for instance, has fallen as the metal's price has shot up. There is a rush to roll out the first physical U.S. copper ETF (see ETF Focus), whose launch could further propel prices of that key industrial metal, already up 20% this year, to $4 a pound. That said, the presence of an ETF on natural gas, U.S. Natural Gas (UNG), hasn't helped gas prices, which are down 35% this year to $3.70 per million BTUs.
The Biggest ETFs
The long rally in gold has made GLD the second-largest ETF.
Assets Recent YTD
Fund/Ticker (bil) Price Total Return*
SPDR S&P 500/SPY $80.6 $121.64 11%
SPDR Gold Trust/GLD 55.8 137.66 28
iShares MSCI Emerg Mkts/EEM 48.0 47.56 16
Vanguard Emerging Markets/VWO 41.0 48.36 19
iShares MSCI EAFE/EFA 36.2 57.92 8
PowerShares QQQ Trust/QQQQ 23.2 53.39 18
iShares S&P 500/IVV 23.1 122.05 11
iShares Barclays TIPS Bond/TIP 20.7 110.92 9
Vanguard Total Stock Market/VTI 15.4 62.47 13
iShares iBoxx $ Invt Grade Corp/LQD 14.5 111.23 12
Assets as of Oct. 31. *Total return as of Nov. 11.
Sources: BlackRock; Bloomberg
Discount and full-service brokers want to capitalize on the ETF boom. Financial advisors who once picked stocks for clients and later selected mutual funds have morphed into asset allocators, and ETFs are an easy and low-cost way to get diversification. The annual expenses on the average one are around 0.50%—one-half to one-third the fees of many mutual funds—and many ETFs charge 0.10% or less.
"There is no better way for individuals to build diversified investment portfolios. Every asset class is available at rock-bottom costs," says Charles Schwab, founder and chairman of Charles Schwab (SCHW).
Schwab has made a major push into ETFs; its clients now hold $100 billion worth of them. The brokerage firm offers managed ETF portfolios, tailored to individual investment goals and risk tolerance, for investors willing to put up a minimum of $100,000. The fee is 0.75% annually for accounts up to $500,000, and lower for levels above that. Overall, the average total yearly fee—including the portion that pays for ETF expenses—is reasonable, at close to 1%.
The Most Traded ETFs
Emerging markets' strength has boosted EEM's popularity.
Assets Average Daily Volume
Fund/Ticker (bil) (bil) ('000 Shr)
SPDR S&P 500/SPY $80.6 $20.5 175,141
iShares Russell 2000/IWM 12.8 3.6 51,638
PowerShares QQQ Trust/QQQQ 23.2 3.5 70,081
iShares MSCI Emerg Markets/EEM 48.0 2.7 57,810
SPDR Gold Trust/GLD 55.8 2.3 17,394
iShares MSCI Brazil Index/EWZ 11.8 1.2 15,923
Financial Select Sector SPDR/XLF 6.0 1.1 77,958
iShares MSCI EAFE Index/EFA 36.2 0.9 15,976
iShares FTSE/Xinhua China 25/FXI 8.5 0.8 18,486
ProShares UltraShort S&P 500/SDS 3.0 0.8 29,627
All data through Oct. 31.
Sources: BlackRock; Bloomberg
Schwab also has rolled out its own ETFs, which have attracted $2 billion in assets and which its customers can trade commission-free. Fidelity also lets clients trade certain ETFs without paying a commission, and TD Ameritrade (AMTD) allows free trades on some 100 ETFs.
One obstacle to growth is unfamiliarity. "If you asked eight out of 10 people, they probably wouldn't know what ETF stands for," says Peter Crawford, a senior vice president at Schwab's client group. Just 17% of Schwab's retail clients now own exchange-traded funds.
AMONG THE KEY differences between mutual funds and ETFS are that mutual funds can only be traded once a day, while exchange-traded funds can be bought or sold whenever exchanges are open. Most mutual funds are actively managed, while virtually all ETFs are passive. Actively managed ETFs probably will remain scarce because government regulators appear loath to approve them. Active managers are reluctant to disclose their holdings daily, partly for competitive reasons. ETFs, in contrast, provide such disclosure.
How do exchange-traded funds add assets? When investors buy shares, the ultimate sellers are designated market makers. When these market makers see their inventories depleted, they create new shares by purchasing the underlying investments and then delivering them to the ETF manager for new shares. Likewise, heavy selling of exchange-traded funds prompts market makers to liquidate the underlying investments, extinguishing shares.
The most actively traded ETF is the original, the SPDR S&P 500 (SPY), which turns 18 years old in January. Others include the iShares Russell 2000 (IWM), which invests in the popular small-cap index; the PowerShares QQQ Trust (QQQQ), which buys stocks in the Apple-heavy Nasdaq 100 index, and the iShares MSCI Emerging Markets (EEM), which holds stocks throughout the developing world.
Who Oversees the Most Assets
Although the industry is expanding, BlackRock (through iShares), State Street and Vanguard manage 82% of the assets in ETFs.
2010
Assets No. Of Inflows
Provider Total (bil) % Total ETFs (bil)
iShares $426.7 45.4% 218 $24.5
State St. Global 213.5 22.7 93 7.3
Vanguard
135.0
14.4 62 32.1
PowerShares
41.7
4.4 117 4.8
ProShares 24.4 2.6 111 4.0
Van Eck Associates 17.3 1.8 29 2.4
Deutsche Bank 11.5 1.2 36 -2.7
Bank of New York 10.8 1.2 1 1.2
WisdomTree 8.9 0.9 44 2.1
Barclays (iPath) 8.3 0.9 38 3.3
All data through Oct. 31. Sources: BlackRock; Bloomberg; National Stock Exchange
Hedge funds use ETFs to bet for or against different sectors in the stock market and as a hedge against their long holdings. Hedge funds, for instance, are believed to account for a high percentage of the heavily shorted SPDR S&P Retail (XRT) and the SPDR KBW Regional Banking ETF (KRE). A hedge fund might short the KRE as a bet against regional bank stocks or to hedge against a long position in bank stocks. Some investors think the emergence of ETFs has made it too easy for big investors to short shares, adding to market volatility.
But some of the largest ETFs aren't heavily traded because they're favored by buy-and-holders. These include several bond ETFs, including the iShares Barclays TIPS Bond Fund (TIP), which invests in inflation-protected Treasuries, and the iShares iBoxx Investment-Grade Corporate Bond (LQD), which holds high-grade corporate bonds.
Vanguard has made the biggest inroads in ETFs, gathering an industry-leading $32 billion in net assets this year, due in part to fees that average just 0.18% annually—a third of the industry average.
THE ISHARES BUSINESS is a great one. It generates operating-profit margins around 40% for BlackRock, which bought it from Barclays for $14 billion last year, when the British bank was reeling from the financial crisis. BlackRock doesn't need highly paid active managers to run the ETFs, and any incremental assets they attract have extremely high margins. The purchase was a shrewd diversification move by BlackRock boss Laurence Fink. A once-obscure bond manager, BlackRock now manages $3.4 trillion in assets and has a $30 billion stock-market value, tops among publicly traded U.S. asset managers.
Vanguard Emerging Markets (VWO) and the iShares MSCI Emerging Markets (EEM) are locked in a battle for supremacy over the hottest current investment group: developing-country stock funds. The iShares ETF is larger at $48 billion, but the Vanguard fund, at $40 billion, is rapidly gaining, thanks to lower fees—0.27% versus 0.72%— and a larger pool of investments that lets Vanguard more closely track the underlying MSCI Emerging Markets index. The Vanguard fund was up 14% through Oct. 31, almost exactly matching the index, while the iShares fund had gained 11.4%.
The most controversial ETFs are those designed to move two and three times the daily change in their underlying indexes by using leverage or financial derivatives. There are 290 leveraged and inverse ETFs, with $40 billion in assets, BlackRock says.
Other Notable ETFs
These all offer an easy way to play specific investments, markets or sectors.
Recent YTD Assets
Fund/Ticker Price Total Return (bil) Comment
iShares Silver Trust/SLV $27.11 62% $9.6 Biggest silver ETF, up 12% in past month
SPDR S&P Dividend/ SDY 51.75 15 4.4 Buys S&P dividend "aristocrats"
SPDR Barclays Capital High Yield Bond/JNK 40.44 13 6.3 Invests in U.S. junk bonds
iShares S&P National AMT-Free Muni/MUB 102.58 4 2.2 Buys U.S. municipal bonds
iPath S&P 500 VIX Short-Term Futures/VXX 45.43 -67 1.7 Offers play on depressed VIX index
Alerian MLP/AMLP 16.02 NA 0.4 Buys master limited partnerships
US Natural Gas Fund/UNG 5.67 -42 2.5 Play on battered gas market
ProShares UltraShort 20+Year Treasury/TBT 36.44 -27 5.4 Anti-Bernanke play on higher rates
Vanguard European/VGK 51.27 7 2.9 Buys European stocks, yields 4%
PowerShares DB Commodity/DBC 26.36 8 4.7 Offers broad commodity exposure
All data as of Nov. 11. NA=Not applicable. Source: Bloomberg
These funds have been criticized because over long periods, they often don't track the underlying indexes. That isn't because of an inherent flaw, but because of the effects of compounding often large daily movements.
As a result, the Financial Industry Regulatory Authority (Finra) said last year that "inverse and leveraged ETFs that reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets." Investors seem to be heeding this advice, because the Direxion 3x financial stock funds have a combined $3 billion in assets, despite enormous daily trading volume averaging 45 million shares for the bullish fund (FAS) and 54 million for the bearish one (FAZ).
To take a simple example, if financial stocks rise 10% one day and fall 10% the next day, the index will drop 1%, to 99, from the original 100 level. A three times leveraged bullish fund would rise to 130 on the first day and then fall to 91 on the second, a 9% drop. The bearish fund would slip to 70 on the first day before rallying to 91 on the second, also producing a 9% decline.
Both the FAS and FAZ have been tough on investors this year and show the pitfalls of an extended investment in leveraged ETFs. The FAS is down just 4%, while the FAZ has plunged 40% and is down 99% since early 2009. All the inverse double-leveraged sector ETFs on the S&P 500 are off sharply this year.
In a cover story at the start of 2009, Barron's argued long-term Treasury yields, then around 2.70%, probably would go higher. That's been the case, with the 30-year T-bond, now yielding 4.25%. The ProShares UltraShort 20-Year Treasury (TBT), however, is down about 10% since then, to 35. It offers the inverse of twice the daily change in the price of long-term Treasuries.
Despite its drawbacks, the TBT is one of the few ways for individuals to bet on higher long-term Treasury rates. The rates already have risen 0.25 percentage point this month and could approach 5% if the Fed's controversial second quantitative easing program boosts inflation and a rout ensues in the bond market. It isn't easy for individuals to short Treasuries. Another alternative is to short the iShares Barclays Capital 20+ Year Treasury Bond ETF (TLT).
Dividend-oriented equity ETFs have been popular this year, including the SPDR S&P Dividend ETF (SDY), which buys S&P's dividend "aristocrats" with a history of 25 years of payout increases, and the iShares DJ Select Dividend Index Fund (DVY), which tracks the Dow Jones dividend index. The SDY's top three holdings are CenturyLink (CTL), Pitney Bowes (PBI) and Cincinnati Financial (CINF), while the DVY's are Lorillard (LO), CenturyLink (CTL) and Chevron (CVX).
It's easy to get low-cost bond exposure via ETFs, including the SPDR Barclays Capital High-Yield Bond (JNK), which now yields 8.5%, and the iShares S&P National AMT-Free Muni (MUB), which yields 3.5%.
Master limited partnerships focused on transporting energy have done very well in the past two years because of investors' hunger for dividends. The Alerian MLP index is up 27% this year, after gaining 62% in 2009. One of the problems with MLPs is that investors get K-1 dividend tax forms—which are more complicated to deal with at tax time than 1099s. The Alerian MLP ETF (AMLP), however, offers 1099s to holders, along with the diversification of 25 MLPs.
The PowerShares DB Commodity (DBC) is a broad commodity ETF with a roughly 50% weighting in energy, while the U.S. Natural Gas fund offers a direct play on natural gas. The UNG is off 45% this year and was down 87% from its 2007 inception through Sept. 30, thanks to weakness in gas prices.
COMMODITY ETFS like the UNG that use futures can be hurt by contango, a term that simply means that future prices are higher than current or spot prices. Contango forces an ETF to roll its spot contracts into higher-priced futures. The UNG has badly trailed gas prices since its creation. That said, it offers a play on the depressed gas market. Prices are down 35% this year, to $3.70 per million BTUs, and are trading at a historically low valuation, relative to oil, now at $86 a barrel. Some investors prefer ETFs that hold physical assets, although that can be tough for some commodities, owing to storage constraints.
Investors can get ETF information from many Websites, including cefconnect.com, xtf.com, etfdb.com and etftrends.com, as well as Morningstar, Yahoo! and Marketwatch.com.
Regardless of how they do it, investors should learn more about ETFs, because they're here to stay—and are growing more important every day.
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