Comment: No stopping explosive growth of ETFs
Four years ago this month, Byron Wien, the venerable chief strategist at Morgan Stanley who has since taken the same role at hedge fund Pequot Capital, published a short, two-page note entitled: “Exchange-traded funds are in your future”.
In his usual pithy style, Wien explained why the idea of being able to buy market or sector exposure in a cheap, listed, liquid format would transform portfolio management.
It proved to be one of his more prescient calls. Notwithstanding the fact Morgan Stanley was promoting itself as the go-to broker for ETF trading, Wien summarised succinctly the simple logic of using tradable index funds to improve the often clunky process of asset allocation.
Since his note was published, assets in ETFs globally have more than doubled to $796bn and the number of funds has grown four-fold to about 1,200. If only one of the providers had spotted the potential for an ETF tracking the ETF market it would have proved a lucrative long position. (Ironically, Morgan Stanley recented closed its ETF broking team).
Last week, ETF Securities announced its assets broke through $6bn, up from $1bn 12 months ago, thanks to its focus on products tracking commodities. It also acquired of a further $3.6bn in exchange-traded gold funds by taking over Gold Bullion Securities.
Echoing Wien, this month another respected commentator, Norbert Walter, chief economist at Deutsche Bank, produced a bullish note on the ETF market. As with Wien, one should approach Walter’s views with a healthy dose of scepticism given the fact his employer has its own range of ETFs – DB x-trackers – to promote. But he nevertheless presents a convincing case for why the dramatic growth in the market is unlikely to falter.
His assessment is rather more long-winded and detailed than Wien’s concise view (German thoroughness versus the straightforward American) but should prompt any sceptical investor or portfolio manager to re-consider their view of ETFs.
Walter points out that the increasing use of portfolio swaps to manage ETFs, as opposed to the manager simply investing in all the underlying securities, lowers significantly the tracking error of the funds – the extent to which their performance differs from the underlying index. Swaps, which can be used for retail funds under Europe’s Ucits III rules, also expand the potential for more fixed income products.
Walter also highlights the role for ETFs in active portfolio management – to manage cash or get diversified exposure to countries or sectors – which can reduce trading costs by 25%, according to Deutsche Bank’s research.
He argues that tax changes in Germany are likely to make ETFs more attractive to wealthy local investors while institutions are only starting to explore the potential of the products.
In Walter’s view, this means Europe’s ETF market is likely to grow by 20% a year to €150bn by the end of 2010.
Not before time, wealth management platforms are emerging to take full advantage of ETFs. Pan Asset Capital Management in the UK is among the latest – headed by former Sarasin Chiswell chief executive Robert Brown with John Redwood, a former Conservative party politician, as chairman.
Virtually all asset classes can be accessed through an ETF, making it possible to create a well-diversified portfolio at very low cost without the headache of deciding which fund managers might outperform the market.
It puts the onus firmly on asset allocation, which is as it should be. Numerous academic studies have shown that this is the decision that really counts.
The investment industry is often accused of intentionally over-complicating the lives of its clients with complex products that earn fat fees while failing to address investors’ needs.
But for once it has delivered a product that is cheap, transparent and flexible. Wien was right, and the future is now.
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