ETFs: 2009 Year-in-Review

The U.S. exchange-traded fund industry continues to evolve and attract assets. U.S. ETFs closed out 2009 with $785 billion in assets, up from roughly $533 billion at the end of 2008. In 2009, investors poured $104.1 billion in net new assets into ETFs, following a banner year in 2008 that saw ETFs draw some $156.6 billion in net inflows. Of the industry's 47% increase in year-over-year total net assets, roughly 40% was attributable to net inflows during the past year, while the remaining 60% was the result of strong market performance.

A total of 134 new ETFs were launched in 2009. There was a relatively broad range of funds introduced during the course of the year, with U.S. equity (37 ETF launches last year), leveraged and inverse (33), fixed-income (30), and international equity (24) being the most popular categories, in terms of product proliferation.

Meanwhile, 54 ETFs were shuttered, 12 of which were exchange-traded notes. For some context, we saw 58 ETFs close in 2008, eight of which were ETNs. Northern Trust threw in the towel on its ETF business in 2009, shuttering all 17 of its internationally focused ETFs. SPA-ETFs also folded in 2009 and closed its six ETNs in March 2009. PowerShares trimmed its fund lineup by closing 19 of its funds in May 2009; the liquidated funds included the firm's FTSE RAFI sector ETFs and dynamic international ETFs

Fund Industry Giants Jump on ETF Bandwagon
In 2009, industry heavyweights Charles Schwab and PIMCO tossed their hats into the ETF ring. Schwab's debut made waves, as the firm offered commission-free trading on its ETFs for any investor trading on the firm's platform. The firm enjoyed a healthy response from investors and closed out January 2010 with more than $500 million in assets in the new funds, which is impressive considering that the funds didn't begin trading until November 2009.

Early in 2010, Fidelity responded by partnering with BlackRock to offer 25 iShares ETFs with commission-free trading on the Fidelity platform. There's also been talk that Fidelity could launch its own brand of active ETFs, though the firm has made no formal filings.

We expect 2010 will see more firms join the ETF party. Other major fund companies that applied for exemptive relief in 2009 to launch ETFs include T. Rowe Price, Russell Investments, John Hancock, and Goldman Sachs.

ETN Product Proliferation Takes a Breather
Only nine of the new fund launches in 2009 were ETNs. Albeit short-lived, the rapid growth of ETNs came to a screeching halt in the fourth quarter of 2008 as the financial crises led investors to adopt a strong aversion to credit risk. Prior to the credit crisis, ETNs seemed to be the next big thing as they allowed providers to offer exposure to many difficult-to-access asset classes and strategies that would be hard to achieve within the ETF structure.

 

Barclays Capital, which retained the iPath ETN business after the BlackRock-BGI merger, was responsible for seven of the nine ETN launches in 2009 (none of which would be practical in the traditional ETF wrapper). Early in the year, the firm introduced investors to a brand new asset class with the launch of two volatility tracking notes. Despite volatility's steady decline throughout the year, the new ETNs were an instant success as investors seeking portfolio insurance loaded up on the funds.

At the end of January 2010, the two ETNs had about $1.3 billion in assets (both ETNs launched on Jan. 29, 2009). The firm's other five new launches were leveraged ETNs based on the S&P 500 Index (two longs and three shorts). The new products offer a different take on "leverage," as they will not reset daily or monthly but will expire on a designated future date.

Without SPY, U.S. Stock ETFs Would Have Shown Inflows in 2009
U.S. stock ETFs saw more than $18 billion in outflows in 2009. However, outflows from  SPDRs (SPY) reached $21 billion for the year. Excluding SPY, the asset class had roughly $6.2 billion in net inflows. Because of the fund's enormous size and volatile flows, it can be worth evaluating ETF flows/assets with and without the ubiquitous SPDRs. The chart below shows monthly ETF flows during the past three years.

The massive swings between net creations and net redemptions around calendar year-end are a phenomenon that goes back several years. For each year in the charts, note the large inflows in December followed by outflows in January. (The impact of SPY can be seen through the U.S. stock category in the chart above.) This trend is nothing new, but there is still no definite theory behind it. Still, it seems reasonable to hypothesize that as year-end approaches, portfolio managers might plow into the SPY in order to maintain market beta and capitalize on the fund's unrivaled liquidity.

Because of its size and ease of trading, SPY can also be an effective tool for portfolio managers handling large asset inflows. Rather than piling up cash while hunting for places to put capital to work, managers can "equitize" cash by owning SPY. Because of the massive volume of daily SPY shares traded, managers can comfortably move in and out of positions without having a market impact.

After the books close for the year and managers start spotting opportunities, the outflows begin. A more cynical thesis for the year-end SPY flows would be that managers are "window-dressing" to avoid reporting large cash balances to clients.

Emerging Markets Helped Drive Asset Growth for International Stock ETFs
International equity ETFs posted a strong year in 2009, both in terms of performance and asset flows. Diversified emerging markets was the most popular category among international funds. We continued to see investors' cost-consciousness on display in the showdown between  iShares MSCI Emerging Markets Index (EEM) and  Vanguard Emerging Markets Stock ETF (VWO). In 2009, VWO took in $9.0 billion in net new assets and ended the year with $19.5 billion in total assets, while EEM brought in approximately $4.4 billion and ended the year with $39.2 billion in assets. ETF industry followers are well aware of the discrepancy in expenses between the two funds. We'll be watching in 2010 to see if the gap in assets continues to narrow.

While the broader indexes grabbed headlines, several single-country ETFs were quietly amassing assets during the past year. In particular, we saw investors flock toward resource-rich countries such as  iShares MSCI Brazil Index (EWZ) ($1.7 billion in total net inflows in 2009),  iShares MSCI Australia Index (EWA) ($1.2 billion),  iShares MSCI Canada Index (EWC) ($1.1 billion), and  iShares MSCI Taiwan Index (EWT) ($1.1 billion).

In terms of product development, the international-stock asset class continues to see activity. The current trend is the slicing and dicing of global sectors. This includes funds like emerging-markets sector ETFs, single-country (ex-U.S.) sector funds, and regional sector funds (Far East, Eastern Europe, Australasia, and so on).

We also expect to see more frontier market funds introduced in the near future. Frontier markets have been one of the primary focuses of Van Eck's ETF business. However, recent filing activity from iShares indicates the industry's 800- pound gorilla might soon be adding to its suite of international-equity funds and encroaching on Van Eck's turf.

 

Fixed-Income ETFs Were the Center of Attention in 2009
Investors flocked to bonds last year, and ETF providers responded to the voracious demand with new product launches. Fixed-income ETFs took in the most new assets of all the broad asset classes in 2009, despite finishing the year with only 77 ETFs--20 of which were muni-bond ETFs. (For comparison, there were about 450 U.S. stock ETFs and 170 international-stock ETFs in the same period.)

PIMCO's entrance into the ETF market should certainly help drive growth within the asset class. The firm launched nine bond ETFs in the second half of 2009 (two of which are actively managed). And in early February 2010, PIMCO ETFs already had more than $550 million in assets.

Aside from ETF newcomer PIMCO, it was the "old guard" that was behind the bond ETF product proliferation of 2009. Vanguard and SSgA introduced seven new bond ETFs each last year, and iShares launched four of its own.

Investors Look to Commodity ETFs for Inflation Hedges
Commodity ETFs saw healthy inflows in 2009, led by  SPDR Gold Shares (GLD), which saw more than $11 billion in total net inflows in 2009 (the most for any individual ETF). The flows into GLD (which has $40 billion in assets) last year represented more than 42% of total flows into the commodity asset class.

Broad-based commodity funds based on rolling futures contracts also saw healthy inflows last year. However, as credit concerns tainted the ETN structure and contango tainted rolling futures strategies, investors increasingly favored physically backed commodity exposure. New providers,such as Jeffries Asset Management, are trying to offer alternative solutions within commodity-producing equities as a result of investor backlash against contango.

European firm ETF Securities made its foray into the U.S. ETF market in 2009. The firm's physically backed gold and silver ETFs have amassed almost $500 million in assets. Early on in 2010 the company also introduced the first physically backed platinum and palladium ETFs to U.S. investors.

Leveraged/Inverse ETF Flows Reveal Questionable Market-Timing Behavior
The year 2009 was an interesting one for leveraged and inverse ETFs. New funds are consistently being introduced, and the funds are regulars on the most active trading lists. Purveyors of these aggressive products vigorously defended the investment merits of leveraged ETFs in 2009, even as misconceptions about the funds caused FINRA to step in with a warning on behalf of investors in June. In addition, several financial advisory platforms placed restrictions on investing in the funds for client accounts.

These vehicles are often used to try to time the market, a task that few can carry out effectively. The job is made even more difficult with sharp market swings like we've seen lately. A glance at the annual figures in the table below shows that investors heavily favored short exposure last year but were pummeled as the market screamed higher. The outflows we saw for the long funds essentially amounted to profit-taking. However, it wasn't enough to offset the wealth destroyed in the short ETFs.

The questionable market-timing can be seen in the graph below. After the market bottomed in March, there was a huge spike in inflows to short ETFs and corresponding outflows for long ETFs. Because of the extreme turnover in leveraged ETFs, we should take the flow data for what it is: estimation. But judging from those estimates, it looks like investors might have been cutting their winners too early (long ETFs) and pouring money into their losers (short ETFs).

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