etfs - past present future morning star presentation

8/8/2019 ETFs - Past Present Future Morning Star Presentation

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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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etfs - past present future morning star presentation

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