From the March 2013 issue of Research Magazine • Subscribe!

To the Next 20 Years: The Future of ETFs

On Jan. 22, 1993 an obscure financial product called the “SPDR” was introduced on the American Stock Exchange. The idea was to help investors gain easy and affordable access to the S&P 500 equity index. Twenty years and $128 billion later, the SPDR (SPY) is the world’s largest ETF and among the most actively traded global securities. 

What began as a movement to track broad based benchmarks has shifted. ETFs now cover narrow markets in a wide swath of asset classes from stocks and bonds to commodities and currencies. It’s already been two decades since the evolution of ETFs, but what will their future be?

Research caught up with Kevin Quigg, global head of ETF strategy and consulting, State Street Global Advisors, to find out. 

What type of impact will the American Taxpayer Relief Act 2012 (ATRA; known as fiscal cliff legislation) have on dividend investing?

 Due to the continued need for income, dividend investing should be undeterred by any of the implications of the ATRA. Furthermore, since dividend and capital gains tax rates remained at parity, taxable investors should not exhibit a strong preference from a tax standpoint. 

Investors concerned about broader opportunities for domestic dividend investing will be well served to consider an ETF that provides access to high dividend yielding equities that have historically been able to return capital to shareholders across all market cycles. One popular example is the SPDR S&P Dividend ETF (SDY). 

Outside of the US, investors should look to companies with strong earnings growth and profitability to fund dividend growth in the future. The SPDR S&P International Dividend ETF (DWX) and SPDR S&P Emerging Markets Dividend ETF (EDIV) are two funds that offer investors an opportunity to diversify their dividend exposure.

The SPDR S&P 500 (SPY) celebrated its 20th anniversary in January. Has the success of SPY exceeded your expectations?

Our intent with all of our SPDR ETFs is to give investors access to investments that help them best meet their needs. As the largest ETF in the marketplace and one of the most liquid securities in the world, SPY has delivered on this goal while exceeding all expectations. 

While the ETF marketplace has evolved over the past 20 years and opened an entire universe of new exposure to equities, fixed income, and commodities, the benefits of SPY—liquidity, transparency, and cost efficiency—still serve as the prime example of how ETFs have changed investing. We are proud to have been a part of that.

So many investors have hopped on the gold bandwagon over the past few years; do you think its diversification benefits are still intact?

 Gold’s lack of correlation to most other asset classes and moderate volatility profile have helped increase its popularity among investors. Going forward, these attributes remain firmly in place. 

SPDR Gold Shares (GLD) is particularly beneficial for managing risk in portfolios because gold is negatively correlated to equities in times of extreme market moves. While gold has elements of both a commodity and a currency, gold may be considered an asset class in and of itself because it has unique supply and demands characteristics relative to other asset classes. 

With central banks moving from a source of supply to a source of demand, gold allocations across the total investable universe remain very small, implying that gold is not an over-owned asset and one that has room to grow in portfolios. 

 It’s been three years since the “flash crash” and ETFs are still blamed for influencing and distorting market prices. Do you think those criticisms are founded?

 In the wake of the “flash crash” a significant amount research and analysis was conducted by State Street Global Advisors, the exchanges, and regulatory bodies to review market structure, exchange processes and other factors leading to the pricing irregularities observed on that day. The result of these reviews made it clear that ETFs were not the cause of the flash crash but rather one of the many securities impacted. 

One of our continuing challenges is to educate the broader investment community on how ETFs are constructed, used in portfolios, and best accessed on the exchanges. Any criticism or confusion surrounding the role of ETFs in the flash crash further underscores the need for more education. 

It seems like active management within the ETF marketplace is at a major turning point. Tell us more.

From an industry perspective, active ETFs remain in the early stages. However, 2012 was an important year for their long-term growth and future viability. At State Street, we launched our first three actively managed ETFs: SPDR SSgA Income Allocation ETF (INKM), SPDR SSgA Multi-Asset Real Return ETF (RLY) and the SPDR SSgA Global Allocation ETF (GAL). These combine the benefits of ETFs as passive underlying vehicles with tactical asset allocation from an experienced institutional portfolio management team. 

Looking ahead to 2013, active ETFs, along with fixed income and advancing indexing, will be areas of continued growth and success for ETFs. In fact, 2013 may see more well-known mutual fund players come into the market as they see the benefits of ETFs as a vehicle for investors large and small. 

The adoption rate of ETFs is increasing among financial advisors. What type of portfolio strategies are advisors using?

At their inception, ETFs were conceived to be a tool for institutional investors to effectively manage risk. However, over the years, financial advisors have come to embrace ETFs for their ability to provide diversified, low-cost, tax efficient and liquid access to various corners of the market. In fact, advisors have found that ETFs are effective tools for portfolio construction on a both a strategic and tactical basis. 

Strategically, ETFs are used as a core investment to gain broad-based exposures. They are also used as satellites to augment existing positions within a portfolio or to provide access to markets that are not easily reached with other vehicles. One example of this is the SPDR S&P Emerging Markets Small Cap ETF (EWX), which provides exposure to emerging market small cap companies. 

Advisors have also found ETFs to be excellent tools for implementing tactical investment opportunities. Additionally, with the growing availability of fixed income ETFs, financial advisors are using them as key tools for targeting and modifying portfolio duration and credit exposure.

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