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2010, Morningstar, Inc. All rights reserved.
ETFs: Past, Present, and Future
Bradley Kay
Associate Director, European ETF Research
Ben Johnson
ETF Strategist, European ETF Research
Conference ID: 60202943
UK Free Call: 0808 238 0673
UK Intl Call: +44 1452 569 335
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Overview
A Very Brief History
The ETF Marketplace Today
What Is An ETF?
What Advantages Do ETFs Offer?
Trends For The Future
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Whence We Came: ETF Market Evolution
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A Very Brief History
1990 The SEC issued the Investment Company Act Release No. 17809. This would ultimately facilitate
the creation of mutual funds that were able to create and redeem shares intraday.
1993 SPDRs S&P 500 begins trading on the AMEX in January.
1999 The Tracker Fund of Hong Kong (TraHK) was launched in November, becoming the first ETF in
Asia.
2000 In April, the European Exchange Traded Fund Company launched a pair of listed diversified return
securities (LDRS) on the Deutsche Borse. The funds, which tracked the EURO STOXX 50 and STOXX 50
indices were co-managed by Merrill Lynch. Later in the same month, iShares launched the first ETF in the
UK, the iFTSE 100.
2003 In February the first ETF on a fixed-income index in Europe was launched. The ETF eb.rexx
Government Germany was issued by Indexchange and tracked the Eurex Bonds Government Germany
index (eb.rexx).
2003 ETF Securities launches the worlds first exchange-traded commodity Gold Bullion Securities in
Australia and London.
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European ETF Asset Growth by Broad Asset Category
Source: Blackrock, Bloomberg
0
25
50
75
100
125
150
175
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Jan-10
ETFAssets(GBP
Billion)
Equity Assets Fixed Income Assets Commodity Assets
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Where We Are Now
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Category/Asset Class # of ETFs Total Net Assets As a % of Total Industry Assets
Europe Equity 424 60,526,666,986 42.47
International Equity 243 32,723,777,179 22.96Fixed Income 153 30,582,153,845 21.46
Traditional Asset Classes 820 123,832,598,010 84.68
Commodity 291 16,982,675,211 11.92Other 18 1,476,473,085 1.04
Currency 22 208,379,461 0.15
European ETF Industry Total 1151 142,500,125,766 100.00
Morningstar Data as of Feb. 2010
Proliferation of Asset Classes
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Proliferation of Asset Classes
In the beginning, ETFs only offered broad index and equity sectorexposure
Now, ETFs offer access to nearly every asset category imaginable
Fixed Income
Fundamental Indexes
Commodities Currencies
Leveraged Equity
Hedge Fund Strategies Niche Sector Slicing
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What Is An ETF?
An umbrella term, covering a broad array of legal structures with aproliferation of abbreviations
ETFs
ETCs
Defining attributes
Tracks a specific index or a strictly-defined portfolio of securities Almost exclusively passive investments
Traded on a stock exchange
A retail investment vehicle by nature
Short-term arbitrage opportunity via daily or weekly sharecreations/redemptions
ETNs
ETPs
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What Is An ETF?
Typically UCITS III compliant
Diversified portfolios of securities: stocks, bonds, derivatives
Physical-replication ETFs
Match their index by holding the actual securities in a uniquetrust
Full or Sampled replication
Synthetic-replication (or swap-based) ETFs
Obtain their index exposure through OTC swap contracts Hold securities in their own trust and/or have collateral pledged
to mitigate counterparty risk
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What Is An ETC?
Formerly Exchange-Traded Commodity, now also currency funds
Typically does not meet diversification standards for UCITS III Single commodity funds
Single currency funds
Debt instruments issued by Special Purpose Vehicles (SPVs)
Degree of counterparty risk varies widely
European Union Prospectus Directive allows broad distribution
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What Is An ETC?
Physically-backed
Only precious metals
Virtually zero counterparty risk
Synthetic-replication
SPV sometimes keeps the ETCs capital, but usually given to total
return swap (TRS) counterparty Collateral may be allocated through a third-party custodian or
simply pledged by the TRS counterparty
Acceptable securities for collateral can vary widely from providerto provider
Read Those Prospectuses!
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What Is An ETN?
Exchange-Traded Note
Debt instrument issued by a backing bank
Senior, unsecured debt of that bank
Substantial counterparty risk!
Not a very popular vehicle in Europe, with only two issuers
Lyxor pledges collateral for their ETNs
Barclays Capital issues uncollateralized ETNs
Much more popular in the U.S., where they have substantial taxadvantages for futures-dependent indices such as commodities
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Innovation, You Say?
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Whats So Great About ETFs?
Incredibly low costs
Intra-day liquidity and real-time trading
Access to new asset classes and strategies
ETFs bring the institutional to the individual
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Low Costs
Passive investments
No expensive analysts
Typically low turnover
Numerous back-office and mid-office efficiencies for providers
Only need to issue and redeem shares with a limited number of
market makers Shifts portfolio trading costs to ultra-efficient market makers or
swap counterparties
Custodial costs have economies of scale due to cross-listings andbroad distribution pulling in assets from across Europe
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Intra-Day Liquidity and Real-Time Trading
Real-time execution means that you know the price you are paying
Can provide more liquid exposure to illiquid asset classes
When corporate bond markets froze in 2008/2009, credit bondETFs kept trading
Market makers arbitrage away premiums and discounts, keepingprices close to fair value
Warning: This shifts the onus of ensuring fair execution onto the finalbuyer rather than the provider
Liquidity differs from fund to fund
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Access to New Asset Classes & Strategies
Funds for in-house use with sophisticated clients are now easilyoffered to retail investors as well
Physical precious metals Asset allocation strategies
Alternative betas
ETFs serve as a wrapper for futures contracts that would otherwisehave too high of a minimum size for retail investors
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Where Do We Go From Here
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Expansion of the Retail Market
Everyone in the industry is waiting for the retail market to appear, butit will be harder than expected
Four major preconditions to a robust retail ETF market in Europe
Increased retail investor demand
Greater trading volume / visible liquidity
Greater transparency
Simple cross-border transactions within EU
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Expansion of the Retail Market: Investor Demand
Need to make the case to individual investors for low cost andpassive investment
Who will be the UKs Jack Bogle?
A critical mass of advisers and other financial professionals looking for
low cost vehicles Organic movement toward fee-based financial advice took
decades in the US
Regulatory pushes in Europe may accelerate the process
(UKs Retail Distribution Review)
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Expansion of the Retail Market: Greater Trading Volume
OTC trading volume does not do much for retail investors
Need to recruit a new sort of institutional investor, as heavy exchangetraders and retail investors have a natural symbiosis in ETFs
Make shorting ETFs easier
Movement toward ETFs as cheaper, easier, and more flexible
than other forms of beta exposure (futures, swaps, etc.)
Moving trade volume onto the exchanges is a self-perpetuating
process once it starts, as greater liquidity makes larger on-exchangetrades easier, which in turn generates more liquidity
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Expansion of the Retail Market: Greater Transparency
Apply MiFID to exchange-traded funds
Reveal all liquidity to all market participants
Help retail investors feel comfortable that the playing field is level
Retail investors want to know what they are holding
Full portfolios published frequently and with little delay
Synthetic replication ETF providers will have to win not just on costand on tracking, but also have to match the openness
Make collateral rules easier to find
Disclose collateral portfolios as well as index portfolios
This information is already available to institutional investors
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Expansion of the Retail Market: Cross-Border Transactions
Liquidity makes ETFs a winner-takes-all competition Institutions will trade across borders for the best execution
Retail investors need to be able to do the same
This trend is already coming to fruition, as several retailbrokerages offer fairly inexpensive trading throughout the EU
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Consolidation in the European ETF Marketplace
This winner-takes-all competition for liquidity will drive consolidationin the ETF marketplace
One or two winners will take the vast bulk of assets andtrading volume for any given index to track
Despite having lower assets and not much growth, many smallerfunds will remain alive on assets from in-house customers
Off-exchange distribution channels can not drive this consolidation
Liquidity and low trading costs are the draw of the top funds, and
they do not carry over to off-exchange distribution
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Product Innovation Will Continue
New entrants in a more mature market can only compete on lowcosts or product innovation
Plenty of new areas ripe for expansion
Fundamentally-weighted indices
Screened indices Active ETFs
Funds of hedge funds
Alternative beta
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