August 30, 2011

What’s Next for ETFs?

iShares’ Archard provides product outlook at Orion/Gemini conference in Denver

The second day of the “Empowering Investment Advisors” conference kicked off in Denver on Tuesday with a look ahead at the ETF space. The conference was jointly hosted by back-office provider Orion Advisor Services and do-it-yourself alternative investment developer Gemini Fund Services (both companies are owned by the same holding company).

Noel Archard, head of product function for BlackRock and responsible for research, development and management of iShares in capital markets, took center stage for the opening keynote.

Archard began by noting the steep rise in ETF product from as recently as 2008, when iShares had 170 ETF offerings, State Street had 80 offerings and other vendors offered roughly 150 products among them, for a total of about 400 ETFs.

“Fast-forward to today, and there appears to be a new product release on a daily basis, with roughly 1,400 products,” he said. “And there’s plenty of room for growth.”

His brief history of the rise of ETFs included the point that they were initially an indexed-based product, but as more money managers and advisors looked for products that mirrored their own investment styles, ETFs that followed custom-built benchmarks began to appear.

“Those that follow the custom-built benchmarks are often more accurate than what active managers can achieve,” Archard said. “They are very black-box and have high turnover.”

He quickly moved through recent innovation in the industry, beginning with inverse ETFs, which are designed to perform as the inverse of whatever index or benchmark it is designed to track. He cautioned the audience about their use, however, noting that clients might not understand the product and how it works, which raises point-of-sale suitability concerns.

He then moved to a discussion of so-called replication ETFs, which mimic other available investment strategies but in an ETF format, and added they have yet to attract a significant amount of assets. He also mentioned ultra-short duration funds and their effectiveness in relation to low interest rates and target date-based products.

Overall, many of the new products have a heavy equity and income focus, he said. About actively managed ETFs specifically, he said they are in “very early stages” and the product needs to develop a performance track record before they will truly compete with passive products.

Archard then moved to the way in which advisors are using ETFs, and noted the larger the RIA firm, the larger its use of ETFs.

“Through a sector line or an overseas allocation is a typical entrance point for advisors,” he said. “Outsourcing the portfolio management portion of their business obviously frees more time for the advisor to spend with clients, and ETFs are increasingly a part of that model, either from an asset allocation or barbell strategy standpoint.”

Archard said ETFs typically account for 30% of the volume on the NYSE/Arca exchange, the primary exchange for ETF trading. He added that recent events caused it to rise to 40%, signaling ETF use in periods of volatility.

“One reason for high ETF adoption rates among advisors, obviously, is due to their low cost,” he said. “ETFs trade at one to two basis points, while the same underlying basket of large cap stocks might trade at one to three basis points if they were broken out. In the small cap space, that spread widens to 14 basis points, compared with one or two for the ETF.”

He concluded with a discussion of what to expect moving forward with the ETF industry.

“We are just beginning to see the deluge [of new product],” he said. “People agree the concept works. It’s not a question of, ‘should I or shouldn’t I use ETFs.’ Eventually they will. But there is a transition period when moving business from mutual funds. We will also see continued innovation in the space, and in active management specifically, you’ll see active managers who basically follow an index and just want to be un-cuffed a bit, versus those that have truly active strategies. And then, of course, there is the big regulatory question mark, which involves a lack of ETF rules, the impact of the flash crash, synthetic ETFs and Dodd-Frank.”

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