ETFs Come of Age

Date: Friday, June 27, 2008
Author: Emii.com

Jack Ablin, chief investment officer of Harris Private Bank and U.S. portfolio strategist for BMO Capital Management, is among the biggest buyers of exchange-traded funds (ETFs) in the country. With $62 billion of assets under management on behalf of individuals and families, Ablin has the firepower to buy whole companies rather than just shares, or whole mines rather than just commodity futures.

Ablin, however, likes ETFs for the same reason that point-and-click retail investors do. “They are the purest and simplest ways to gain entry to a market or an asset class,” he said. “We are global macro investors, so the most important decision we make every day is to get our clients exposure. With index funds, I don’t have to worry about picking a lousy manger.”

That is also why Ablin is not inclined to pursue the brave new world of actively managed ETFs, which is not to say that he does not manage his portfolios actively. “We have no pride of authorship,” he said. “We just want to be in the right market at the right time and out of the wrong market at the right time. Our edge is that global macro approach, as opposed to the bottom up. We bring the experience, the intelligence and the understanding.”

Specifically, that means that Ablin’s team can make very tactical customized allocations. “We can write options against ETFs, we can short them or buy inverse ETFs,” he said. “We can use inverses in long-only IRAs that prohibit shorts. We can build a very tight allocation. There are some very interesting bets out there. ETFs have opened whole new strategies that have not been fully exploited yet.”

Ablin said he sees about five new ETFs every week and advises some of the leading providers on what new funds he would like to see. “We are looking at more sector strategies, and we are about to launch a country strategy over the next few months,” he added. As a result, he is looking at more currency harvesting vehicles, covered calls using ETFs and more shorts.

Growing and Evolving

According to Paul Mazzilli, director of ETF research at Morgan Stanley, trading flexibility, low expenses and exposure to major indices made ETFs popular with investors of all sizes since they first gained wide use in the late 1990s. “The first fund was the SPDR in 1993 and, just four years later, there were 19 funds with $7 billion in assets,” he recalled. “Growth in assets has averaged 25-35% per year, and growth in the number of listings has been even greater. I expect that to continue.”

Mazzilli noted, however, that 80% of the assets are concentrated in the top 50 funds. That is partly because the market operates in two main tiers, he explained. There are the hedge funds and other active traders, and there are the institutional investors and high-net-worth individuals, most of whom are working with advisors. ETFs give exposure to investments, especially commodities and currencies, that are not easily accessible through conventional asset classes.

The best news, Mazzilli said, is that the ETF sector is still in its infancy compared to open-ended funds. “The market will become dominated by the majors,” he predicted. That is already happening, as the league table is dominated by Barclays’ iShares with $326 billion in assets, or roughly 53% of the market (see table below).

The second largest issuer in terms of assets, State Street, is less than half the size of Barclays with $133 billion. Vanguard, in third place, is about one-third the size of State Street. There is a bit more balance in number of funds, with second-place PowerShares at 109 behind iShares’ 159.

Mazzilli also noted that some mid-sized players, including Van Eck and WisdomTree, have some strong performing funds and a few boutique houses such as Claymore and First Trust do as well. “Now that the market has been opened to actively managed ETFs, there is going to be an even greater appeal to major fund managers like Eaton Vance or Black Rock,” he added.

Simple growth is what is attracting the strong interest from the big players. “We saw $6 billion in new money in the first quarter of this year,” Mazzilli said. “There are new issues every day, and fixed income is getting a lot of attention.”

Furthermore, ETFs have been moving from general to specific. “Initially, we saw the volume moving into the broad market indices,” Mazzilli said. “Then there were the sector funds. Now we are seeing individual industries. We are going to see more slicing and dicing of markets, including more commodity funds and more currency funds.”

Seeking a Competitive Edge

With its acquisition of PowerShares, Invesco is taking aim at Barclays’ top spot. In May, PowerShares S&P 500 BuyWrite Portfolio (PBP) was named “Most Innovative ETF” at the 7th Annual Forum on Closed-End Funds and ETFs. Bruce Bond, president and CEO of Invesco PowerShares Capital Management, noted that the growth of ETFs has been driven all along by innovation.

“At the end of 2006, there were 343 funds with $406 billion in assets in the U.S.,” Bond said. “By the end of last year, there were 670 funds with $600 billion in assets. Worldwide, there is $800 billion. What first attracted the institutional investor was the ability to hedge risk in a specific area. For the retail investor, the attractions have been the simplicity and tax efficiency.”

Bond is not overly concerned that ETFs will suffer the same dissipation that open-ended funds did when investors and professionals alike realized there were more funds than individual equity listings. “What did the mutual fund S-curve look like at this level of assets?” he asked. “There is roughly one-third the number of ETFs today as compared to the number of mutual funds in 1985, when we had $600 billion in that business.”

Not surprisingly, Bond also is enthusiastic about the prospects for actively managed ETFs. “Those are not a contradiction,” he insisted. “The ETF is a structure, a vehicle like a note or a unit investment trust. It is not necessarily active or passive. We want to offer investors the structure of their choice, whether it is mutual fund, ETF or separately managed account.”

Bond also recalled the ‘optimized index fund’ that gained attention around 2000. The idea was not active management, but to leave out the obvious dogs from an index fund. At first, it was a way for managers and advisors to counter the popular rush to index funds. But he noted that a lot of big pension funds liked the optimized index as a way to try to boost returns.

In some ways, the May recognition for the latest PowerShares offering was an anniversary party - PowerShares made its debut with the Dynamic Market Portfolio (PWC) on May 1, 2003. “PWC is rebalanced every quarter according to the Intel index, and it discriminates between good and bad sectors,” Bond said. “Our turnover has been 100% each year for the past five years, and we have managed to outperform the S&P 500 with no capital gains.” The idea, he explained, is just to have a better Sharpe Ratio. “Active ETFs will do that,” he added. “I believe that the SEC is looking to adjust what they are doing and, as that happens, the active strategy will carry the sector forward.”

At present, the tightly focused industry funds are driving growth. “The strong performers this year—the ones getting the most interest, not necessarily the ones with the most inflows—are the clean energy funds and the water funds, both domestic and international,” Bond said. “Commodities in general are doing well, especially agriculture.”

All of PowerShares index-based ETFs have some active element built in, Bond noted. He likes to call it ‘intelligence built into the index.’ “That is what we have tried to introduce to the market: intelligent indexing, intelligent exposure and intelligent access,” he added. --This is part one of a two part story. Part two will run on Monday.