ETF Year in Review 2011

The market took a beating this year, but exchange-traded funds themselves had a banner year despite some snags. Three global regulators--the Financial Stability Board, the International Monetary Fund, and the Bank of International Settlements--released reports in quick succession warning of the systemic risks created by ETFs. Their concerns spurred a much-needed debate and prodded European ETF sponsors to disclose their risks more transparently. Fortunately, the U.S. ETF market is much more transparent and conservative, so most commentators focused their fire on the alchemical "synthetic" ETFs that European investment banks are so fond of. Despite the headlines, U.S. ETFs gathered an extra $100 billion, handily beating flows to the gigantic U.S. mutual fund market. I thought that, amid this sea change, I'd digest this year's major trends and pull out my crystal ball to peer into the future of the industry.

The Best of This Year's Crop
Sponsors launched more than 300 ETFs this year, boosting the ETF population to just under 1,400. I sifted through them to identify the ETFs that exemplified the qualities that made the industry so popular: market-leading low costs and broad appeal. One clue was asset flows, as I've found that good ideas tend to attract the bulk of assets. The two clear winners were  iShares High Dividend Equity (HDV) and  PowerShares S&P 500 Low Volatility (SPLV), which have more than $800 million each in assets. (Morningstar licenses HDV's index to BlackRock and earns asset-based fees.) Both are low-volatility value funds with reasonable costs. I like both funds a lot and the low-volatility theme in general--in June, I urged investors to seek low-volatility strategies.

IShares deserves special praise for its suite of low-volatility ETFs. The funds have among the lowest fees in their respective categories, with  iShares MSCI Emerging Markets Min Vol Index (EEMV) only a tad pricier than the low-cost giant  Vanguard MSCI Emerging Markets ETF (VWO). SPLV's success and iShares' salvo forced the first movers in the low-volatility space, Russell ETFs, to slash its fees by about 30 basis points. Competition is a beautiful thing.

    Expense Ratio iShares MSCI USA Min Volatility (USMV)   0.15% iShares MSCI EAFE Min Volatility (EFAV)   0.20% iShares MSCI Emerging Mkt Min Vol (EEMV)   0.25% iShares MSCI All Country World Min Vol (ACWV)   0.35%

And the Worst ...
 UBS E-TRACS 2x Wells Fargo Business Development Company ETN is awful. Business development companies are publicly traded private-equity firms that lend to small, less-creditworthy firms. Many BDCs represented in the note's index are micro-caps. Naturally, BDCs are extremely risky, but they pay fat dividends. This fund takes the mad step of leveraging these less-liquid, opaque, and often tiny stocks. Aside from questionable investment merit, it is expensive. The note carries a hefty 0.85% "Annual Tracking Fee" and "Accrued Financing Charges" that add up to at least another 0.40% annually. This pricing is rich but not quite egregious. I can't say the same about how the note is structured. It's clearly designed to sport an eye-popping yield--more than 22% according to UBS' website--but that yield is distributed to investors wastefully. The key cost advantage of an ETN is its extremely favorable tax treatment, allowing a tax-unfriendly asset class to be repackaged in a lean, tax-avoiding machine. BDCL fails to take advantage of its one potential saving grace. It seems designed to take advantage of naive, yield-seeking investors. No institution or savvy investor would touch this product with a 10-foot pole, except maybe to short it.

Factor Investing Escapes the Ivory Tower
A small but meaningful trend was the launch of numerous "factor" ETFs. Russell led the charge with its investment style, momentum, volatility, and beta ETFs. Credit Suisse launched several more hedge fund replication ETNs. Startups QuantShares and FactorShares joined the fray, too. Most investors are probably perplexed by these products. Who would want to buy them? Well, institutions, for one. Sophisticated investors have for decades examined their portfolios as a collection of risk factors, the true drivers of asset class returns. These ETFs engineer ways to separate and purify factor exposures.

I'm not full-throatedly backing these products for the public. Most are too expensive and unfamiliar. But I think that factor ETFs, as they gain liquidity and shed expenses, will begin taking market share away from hedge funds, much in the same way that passive market-weighted ETFs have eaten into the actively managed fund pie. In the not-so-distant future, advisors could be slicing and dicing factor exposures for their clients.

Actively Managed ETFs
When PIMCO announced an ETF version of its flagship Total Return fund this year, many failed to grasp its true significance. By dint of the fact that PIMCO is one of the biggest asset managers and Total Return the biggest mutual fund in the world, it's tempting to think of the PIMCO ETF as suigeneris.I think that's a mistake. I take it as a sign of things to come. PIMCO is aware the ETF will eventually cannibalize the pricier advisor-sold and retail share classes, which comprise nearly $100 billion of Total Returns' $240 billion in assets. PIMCO is undermining the enormous distribution complex that feeds off of sales loads, 12b-1 fees, and platform costs. In the long run, competition will work its magic (barring unfortunate regulatory or legislative changes), and the extractive middle men will be sidelined. Investors will enjoy lower costs, and fund companies like PIMCO will enjoy part of the rents that previously accrued to others. I expect other fund companies to make the same calculation, especially if a truly opaque ETF structure takes off, opening the way for stock-pickers to ply their trade without fear of front-running.

In All, a Good Year
I'm glad to see ETFs growing and innovating and disrupting. This year was more interesting than most, but the main themes were not new. Low-cost ETFs took in the vast majority of assets, there were some bad new ETFs, and ETFs continue to chip away at the market shares of pricier structures. I look forward to what 2012 will bring for the industry.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.