Exchange traded funds (ETFs) and exchange traded products (ETPs) are some of the more innovative new financial products to emerge from the financial industry in the last two decades, since the first ETF was launched in the US around 1993.
The challenging market condition of 2007-08 caused a significant shift in investors’ risk appetite in the evaluation of counterparty risk and their desire for liquidity. With increasing demand from institutional and retail investors in equities, fixed income and alternatives, the providers of ETFs have continued to expand their product range.
The popularity of the product can be ascertained from the fact that the assets have seen a compounded annual growth rate (CAGR) of 39% for the last one decade and surpassed assets under management of $1.4 trillion. They have opened a new era of investment opportunities and allowed investors to gain a broad exposure with relative ease, transparency and lower cost.
ETFs are like open ended funds that provide daily portfolio transparency, listed and traded on exchanges.
ETPs is a wider definition, similar to ETFs in the markets, though they do not use the mutual fund structure. However, we have used this interchangeably in order to make readers familiar with the larger picture.
There are close to 168 providers having more than 3500 products and 7300 listings across 50 exchanges. The numbers are growing as we read this article. The top 3 providers (iShares, Vanguard and SSGA) account for more than 70% of market, while the top three funds have a 16% market share. While ETF assets have nearly doubled since early 2007, ETF trading volumes have quadrupled during this span due to increased trading velocity (led by the popularisation of leveraged ETFs).
Today, the ETP assets are distributed predominantly in equities (75%), fixed Income (14.7%) and commodities (9.6%) of the total ETF assets. Currency and multi assets have negligible presence. ETFs have found favour among both retail and institutional traders as a means of expressing short-term views in addition to offering investors an investment vehicle with a low fee structure and potential tax efficiency advantages. In the past three years, ETF volumes have grown at a 60% CAGR, compared with 17% annualised growth for the US cash equities.
A big draw in favour of ETPs is the saving in expenses it offers in comparison to products. The equity and fixed income ETFs have a fee of around 30 bps and 18 bps in comparison to 100 bps and 18 bps for traditional equity and fixed income products. Moreover, ETFs are bought on a commission basis just like other shares or funds, purchased on margin, lendable, and do not have sales load.
If you think the existing fee structure on ETPs are high for you, then you may not be surprised to hear that Charles Schwab, a broker in the US, has gathered ETF assets of more than $1.4 billion this year after it fired the first salvo in a price war with the launch of eight funds, which investors could buy free of dealing charges. Schwab’s move forced competitors to follow suit.
A detailed study by Goldman Sachs on ETFs provides a good insight on evolution and growth of ETFs in the US and its impact on the US asset management industry. Passive fund management grew to 18% of total funds under management in 2009 from around 9% a decade back. While ETFs have increased their initial market share — from passive fund management accounting for around 16% in 2001 to more than 50% of the passive fund strategy, and accounting for 9% of total asset under management.
However, the fee contribution at $1.6 billion per annum from ETFs is quite low in comparison to fee from traditional asset management market of $17 billion per annum.
Considering the annual growth projections of more than 30% for the next decade, it is a certainty that revenue from ETFs will grow while making a dent on the revenues of the traditional fund management as well as broking industry, which has to thrive on active fund management.
Gold ETFs provide interesting insights into how investments are shaping up with the advent of ETFs. The ETFs hold more than 2,000 tonnes of gold, the sixth-largest reserve in the world, amounting to close to $100 billion next only to countries like France, Italy and institutions like IMF. Considering the state of ballooning sovereign debt, as well as wider acceptance of ETFs by investors in the emerging markets, gains from ETFs’ investment in gold and other precision metals are going to increase significantly.
However, ETFs/ETPs do come with some inherent risks.
One of the most prominent risks is the divergence of the fund vis-a-vis the underlying commodity, also called as tracking error. Assuming an ETF invests in a particular commodity by investing in the future contract, the cost of rollover in case of contango or backwardation can create significant high tracking error for the fund.
ETFs also carry label risk, where the nomenclature of the fund may be different from investment made by the fund.
Investors should also know that all ETFs are not taxed the same and that a few carry counter party risk to banks also.
Indian investors have limited choice at home, but they can invest abroad $200,000 per annum per individual. This opens a whole new investing world to them.
The writer is managing partner and CEO of Vallum Capital, an investment firm based in Mumbai.
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