What's in the ETF Pipeline for 2009 and Beyond?
Panel sheds light on some new products and other potential opportunities.
The panel at the Inside ETFs Conference titled, "What's in the Pipeline: New ETFs of 2009, 2010 & Beyond" was interesting for a couple of reasons. Obviously, there's a great deal of interest concerning what type of innovative products investors can expect in the near future. However, what made the dynamic of this panel intriguing was that the heads of three of the premier ETF providers were all sitting at the same table discussing what's ahead for their respective firms in terms of strategic new product launches and the general direction of the industry. The panel included Jim Ross, president and senior managing director for State Street (STT) Global Advisors, Noel Archard, head of product research and development for Barclays (BCS) Global Investors' iShares, and H. Bruce Bond, president and CEO of Invesco (IVZ) PowerShares Capital Management LLC.
Morningstar's Take: While the panel was informative (and entertaining), we'd be comfortable going out on a limb to say that we can expect more than what was revealed by the panel in the coming year, in terms of new product launches and filings. One way to think about this panel is that it was made up of three of the top players in the industry who are continuously competing in a high-stakes game of poker (for assets under management). Considering the rapid growth of the industry, the intense battle for market share, and the rising pace of product innovation within the industry, it would seem foolish for any one player to "show all of his cards." Nonetheless, we were pleased with the level of disclosure--even though we were already anticipating many of the topics that were discussed.
The panel kicked off with an overview of the state of the industry. To no one's surprise, the topic of leveraged ETFs quickly emerged. Archard of Barclays lightened the mood of the panel when he turned to Ross of State Street and joked, "We're coming out with a 10-times levered ETF; can you beat that?" All jokes aside, moderator Ben Cukier started off by pointing out that about 60 ETFs closed in 2008, compared with just five over the past 10 years. This begged the question: Are there already enough ETFs on the market? As expected, this panel argued that there are more asset classes and slices of the market available to index and make available to investors. Surely, the Darwinian effect will continue to play out as funds that fail to gather meaningful assets or trading volumes will fall by the wayside. For instance, one could argue that the domestic broad market and sector funds already on the market have their respective slices of the market pretty well covered, leaving little to no room for additional competitors to offer similar products. That said, the panelists unanimously agreed that there's plenty of runway for growth in areas such as target-date funds, risk-based strategies, actively managed ETFs, international (particularly emerging-markets) funds, and even ETNs that offer investors exposure to more "exotic" or hedge-fund-like strategies. In fact, Bond of Invesco's PowerShares noted that he doesn't see product development slowing in the next few years.
Morningstar's Take: Certainly this panel has an incentive to promote further innovation and product proliferation in the ETF industry, as the members of the panel are all intimately involved with the development of new products. In short, the panelists make their living on attracting assets and bringing new products to market. So, their response to the opening question shouldn't come as a surprise. That said, we do agree that there is room for more ETFs. While the currently available lineup of exchange-traded products pretty well blankets the investment universe, we think that there are still opportunities to go back and "fill in some holes." Don't get us wrong, though; we still think that funds that fail to live up to their mandates and funds that don't offer investors any advantages over similar and competing products will continue to shutter. Nonetheless, the bottom line is that innovation doesn't appear to be slowing anytime soon in this ever-dynamic and growing industry.
Through the malaise of 2008, an area where each of the represented fund providers saw meaningful growth in demand was in fixed-income and related products. This was apparent in the fund flows that we tracked over the past year, as we saw investors flee risky assets (stocks) in search of safer havens (bonds). Needless to say, we can expect to see more fixed-income products make their way to market in the near term to satisfy this demand. We think this is a net positive for investors, as fixed-income ETFs have made it much easier for individuals to incorporate bond exposure into their portfolios. International bonds (issued by developed and emerging countries) in particular represent a compelling and relatively new segment of the market with plenty of runway for growth.
Interestingly, the ETF structure actually acted as somewhat of a price discovery mechanism during the turmoil and market stress of 2008. Archard noted that the utility of the ETF product was on display through the final three months of the year when there were serious dislocations in the bond market. In fact, the market prices of some bond ETFs deviated significantly from their NAVs. While many were quick to point fingers at the ETF products themselves for failing to track their benchmarks, the fact of the matter was that the market prices of the ETFs turned out to be more accurate reflections of the given bond portfolios' values. Let's not forget that frozen credit markets were at the heart of the market downturn (and panic). So, when the underlying bonds weren't trading (no bid price), the NAVs of these funds went haywire. In reality, not all debt issues were poised to default (despite what the grim economic backdrop led many to believe), and the market prices of these bond ETFs were attempting to discount the future interest payment streams and probabilities of default throughout this turbulent period. Hence we saw severe dislocations between the market price and NAV of several fixed-income products near year-end.
Morningstar's Take: We agree wholeheartedly with the panel regarding the opportunity to roll out new products in the fixed-income arena. How many average retail investors make an effort to assemble a portfolio of individual bonds in order to gain their appropriate fixed-income exposure? Not many. The truth is that most investors achieve their bond exposure through actively managed traditional mutual funds. In the end, we think that advisors and individuals win with the addition of the (low-cost and transparent) ETF option to their tool kit. The large spreads that many fixed-income products displayed during the roughest patches of the credit crisis (it was the underlying bond market that was broken, not the ETFs) is still concerning. On one hand, the fact that the ETFs continued to trade is a huge positive in their favor. On the other hand, these premiums and discounts make it difficult for investors to know exactly what it is they own. If anything, we think this speaks strongly to the strategy of using a fixed-income ETF in conjunction with a traditional bond portfolio.
The session then went in a different direction with a discussion of the product-development process. Ross first noted the two hallmarks that his firm evaluates when looking at new products--clarity and control. Clarity refers to the transparency and liquidity of the underlying market (the conflicts that arose because of foreign-investment restrictions in India come to mind), whereas control relates to whether or not the firm has an opportunity to improve on an existing product. Archard added that the product-development process at Barclays begins with engaging with clients. In fact, he noted that many ideas for new products come from clients' requests for certain types of market exposure. According to Bond, his firm is always on the lookout for noncorrelated assets. Bond also makes no secret about his firm's plans to aggressively pursue getting actively managed ETFs to market.
Morningstar's Take: This part of the session was straightforward. One thing that we gleaned from observing the different responses is that it seems as though each of the providers has identified a niche or core strength that shapes their product-development process. For example, we get the feeling that Barclays is now catering more toward the institutional client by working with these large investors and then tailoring products to meet their needs. State Street, on the other hand, seems to be more interested in educating financial advisors about their existing lineup of products. PowerShares has staked its claim by pushing the traditional indexing boundaries with its intelligent and quantitative-active products.
Bond's talk of pressing the boundaries and being creative in the product-development process led the panel to discuss the regulatory environment and how it may impact the industry going forward. Without a doubt, the regulatory environment in 2009 will be significantly different than in the past. To date, the Securities and Exchange Commission has been fairly lenient with respect to allowing providers to roll out new concepts. However, turnover at the SEC (as the new administration settles into office) could end up stalling the progress made on this front and might even create new challenges. Nevertheless, the firms represented on the panel still have "exemptive relief" under some of the provisions of the Investment Act of 1940. Thus, innovation and new product development won't stop altogether in the near term. Ross stated that while the regulatory environment will be tougher, he (and his firm) is supportive of that and believes that, overall, it could be a good thing to get some stronger checks and balances in place. Bond then warned that exemptive relief from the SEC could lead to a new wave of product proliferation and new entrants into the industry. While this will translate into more choices for investors, it also means that investors will really need to do their due diligence to understand what is what.
Morningstar's Take: The ETF vehicle has performed relatively well in the recent market turmoil compared with the issues roiling the hedge fund and actively managed open-end space. We think that this could help in retaining some flexibility with the SEC. On Bond's point on the potential for product proliferation, we couldn't agree more. As new (and sometimes obscure or esoteric) products hit the market, it will be all the more critical for investors to do their "homework" and really understand what's under the hood of these products--their names can sometimes be misleading. For Morningstar ETFInvestor subscribers and Morningstar.com Premium Members, our research team will be here each step of the way to guide investors through this dynamic and growing industry.
Finally, after spending most of the session discussing higher-level industry topics and slyly avoiding delving into too much detail, we caught a glimpse of just where the panelists see the most opportunity in the short run. Right off the bat, Archard chimed in to note that the target-date funds that his firm recently rolled out were aimed at laying the groundwork for getting ETFs into 401(k) plans and 529 college-savings plans. In terms of new products from his firm, Archard noted that it will be rolling out a pair of ETNs based on the Chicago Board of Options Exchange Volatility Index, or the VIX (commonly referred to as the market's "fear gauge"). This has been a long time in coming, as providers have struggled with some of the challenges of bringing such an exotic product to market (note that the market for VIX futures only dates back to March 2004). Morningstar ETF Analyst Bradley Kay actually suggested that a fund provider bring such a product to market in an article published in early September. Interested investors can keep their eyes out for iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), which are scheduled to begin trading Jan. 30.
PowerShares will continue on its journey to bring more actively managed ETFs to market, according to Bond. While it's taking time to get through the regulatory process, Bond believes that it is making strides. This is another hot topic that will surely dominate the ETF headlines in 2009. Two markets where Bond believes that active management has strong potential are money markets and short-term corporate paper--two areas of the market that are liquid and transparent themselves. In his view, it makes the most sense to get the ball rolling on the active-management front by beginning with the most transparent and liquid markets (apprehension about disclosure policies is a key issue surrounding bringing traditional active management to ETFs). Another area where Bond sees an opportunity for new product innovation is within the managed-futures arena. When the topic of managed futures came up, all of the panelists concurred and then proceeded to smirk, but they remained tight-lipped. One way to interpret the panel's reaction might be that each of the providers has something currently in the development phase and were thus hesitant to divulge too much information.
Morningstar's Take: We are supportive of ETFs making it into 401(k)s and 529s, as it would offer investors additional low-cost tools to meet their long-term financial goals. Unfortunately, there are still plenty of hurdles to clear before widespread adoption occurs in major retirement plans--the main conflicts seem to be with the behind-the-scenes "plumbing" as well as custodian and record-keeping issues. As far as the VIX ETNs go, we think that they're interesting products that could serve as valuable portfolio diversifiers. Until the release of these products, individual investors have had a hard time speculating on the VIX, as futures in the index require minimum investments well over $10,000. The new iPath ETNs from Barclays now open this negatively correlated asset class (volatility) to the masses--stay tuned for a thorough analysis of these products, as the ETF Research Team plans to collaborate shortly with our colleagues at Morningstar OptionInvestor.
We're glad to hear that PowerShares is making progress in guiding its actively managed strategies through the regulatory gauntlet. With respect to actively managed ETFs, we'd note that portfolio holdings will still be made available at the end of each day. If these products don't sacrifice the transparency that has made the ETF such an attractive investment vehicle in the first place, then we think that they could generate substantial interest in the marketplace. The resounding message coming from this session of the conference was that the pace of innovation in the ETF industry doesn't appear to be slowing anytime soon. We encourage interested readers to continue checking back with us to get the latest scoop on new exchange-traded products as they file for registration and/or begin trading.
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John Gabriel does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.