The ETF business wasn’t always this fun. And the people at Barclays Global Investors (BGI), sponsor of the iShares, can attest to it. In 1996, when few investors were aware of ETFs, the company banked on their future by quietly launching a series of single country funds. Even though the early years were spent doing a lot of explaining, BGI’s hunch eventually paid off as their ETFs zoomed from obscurity to stardom.
BGI’s early commitment to ETFs that touch international markets has paid off handsomely. Today, the iShares MSCI EAFE index accounts for some $22
billion in assets, making it second in size to the venerable SPDRs, which track the S&P 500. All together, BGI had 102 ETFs with almost $171 billion in assets ending
December 31, 2005. It continues to lead the U.S. market in terms of both the number of ETFs offered and assets.
Realizing their influence, the company has targeted financial advisors in its marketing efforts over the past few years. The iShares website has won the praise of many advisors for its asset allocation tools and other convenient features. Nevertheless, BGI has not quit in its pursuit of reaching the retail masses. Josh Taylor of Kompass Financial in Englewood, Colo., thinks that BGI has done a good job of educating investors. Referring to the iShares print materials he states,
“It provides good basic information for the consumer to learn about this concept in investing. It helps my clients to have an understanding of what their money is invested in.”
Let’s look at the key asset categories that the iShares funds cover:
Broad Market Indexes
The broad market ETFs offer an excellent starting point for constructing investment portfolios. They typically offer unconfined exposure to stocks in all asset categories, including large-cap, mid-cap, small-cap and micro-cap. With one simple trade, instant diversification is easily attained.
The iShares offer six ETFs in the broad market category. The NYSE composite, for example, covers all common stocks, ADRs and REITs listed on the New York Stock Exchange. For those that want an even broader span, there are three versions of the Russell 3000 index, with value, growth or blended approaches. Russell broad indexes are composed of stocks in all capitalization categories.
In the landscape of domestic indexes, there are plenty of iShares to choose from. In the large-cap category, the iShares S&P 500 (Amex: IVV) is the fourth largest ETF, with just over $14 billion. In the mid- and small-cap categories, iShares track indexes by Morningstar, Russell, and Standard & Poor’s.
One area that ETFs were lacking was exposure to micro-cap stocks. The iShares Russell Microcap (NYSE: IWC) filled that void in 2005. The index includes 1,000 of the smallest stocks within the small-cap Russell 2000, plus it scans an additional 1,000 outside companies in the micro-cap universe. Financial services, health care, and technology collectively represent almost 60 percent of the sector
exposure in this index.
Industry & Sector Indexes
For sector investors, iShares offer 21 ETFs that follow industry indexes ranging from basic materials to technology. Dow Jones and Goldman Sachs provide most of the indexes, while Cohen & Steers provides exposure to its Realty Majors REIT index (NYSE: ICF).
Three of the Goldman Sachs technology indexes offer concentrated exposure within this sector. The iShares Goldman Sachs Networking (Amex: IGN), iShares Goldman Sachs Semiconductor (Amex: IGW) and the iShares Goldman Sachs Software (Amex: IGV) each slice and dice this sector into niche areas. Some investors have been attracted to the high options premiums of these ETFs, because of their volatility.
Single Country Indexes
No other fund company has more individual country ETFs. Many of these funds were launched in 1996, making them among the oldest ETFs. The iShares MSCI Japan (EWJ) with $13.08 billion in assets is the largest single country fund. Other funds that have had a surge in assets are the iShares MSCI South Korea ($1.38 billion) and Brazil indexes ($1.22 billion). Both were among the best performing country funds in 2005.
“If you have a lot of conviction, single country funds can work. For example, Canada could be considered a natural resources play, whereas Taiwan is a good way to have exposure to the semiconductor sector,” says Jane Husband, Vice President of Main Management in San Francisco.
The iShares have six bond ETFs. All of them track Lehman indexes, except one, which is the Goldman Sachs $ InvesTop Corporate Bond Index.
Interest rates and the fear of inflation have been on the rise, leaving some bond investors skittish. The iShares Lehman TIPS Bond (NYSE: TIP) protects against rising inflation. It pays monthly income in accord with its coupon face plus any adjustments to the value of its holdings based upon fluctuations in the consumer price index (CPI).
While investors can’t control the direction of interest rates or Fed policy, they can control costs. With bond funds, expenses are even more crucial than stock index funds. Since bond returns are generally lower, investors who pay the lowest expense ratios usually keep the most. It’s not uncommon to find managed bond funds that charge four to five times their ETF counterparts. The category average for fixed-income bond ETFs
is 17 basis points.
Morningstar popularized the style-box grid. While the company has successfully used it as a means of classifying mutual funds into the growth, value or blended categories, some doubt its usefulness to ETF investors. Max Rottersman, president of Fund Expenses, says, “Few financial professionals believe there’s a big difference between value and growth anymore. Morningstar style boxes are more a marketing tool than true representation of reality.”
But James Squyres, president of Buyside Research, is bullish on the funds. According to a recent study of earnings growth by his company, he argues, “Aggregate 3rd quarter earnings growth in four of the iShares Morningstar funds [JKE, JKF, JKH & JKK] is in the top quartile of all ETFs.” On a valuation basis, Squyres says this makes the stocks within each of the four ETFs attractively priced. His research concluded that ETFs with high EPS growth and low P/E ratios have outperformed their peers over the past five years.
Despite having one of the broadest menus of index ETFs, there are still many areas not yet represented by the iShares family. Many advisors have called for single country funds that give exposure to economies like India, Israel and Russia. Others see opportunities for more ETFs in the fixed-income space, particularly on the foreign bond side.
Even though sector funds represent the most crowded ETF category, some advisors still think there’s room for more. “There are about 63 sub-industries and only 15 percent to 20 percent of those are covered by ETFs, so there’s a lot more room for growth,” states Husband of Main Management.
And while ETFs appear poised to crash the commodity and currency markets, it remains to be seen what other areas will be developed. Regardless of what unfolds, expect BGI and the iShares to be right in the middle of the mix.
Mergers & Acquisitions
PowerShares Scores $60 Million Buyout
AMVESCAP PLC (NYSE: AVZ) has announced its plan to purchase PowerShares
Capital Management for $60 million plus added financial incentives.
PowerShares, based in Wheaton, Ill., currently has 36 ETFs and roughly $3.8 billion of assets under management. Although much smaller than its rivals, the company has made an impact on the ETF marketplace by emphasizing enhanced indexing, which aims to outperform traditional benchmark indexes. PowerShares launched its first two ETFs in 2003 and has continued to add new funds at a frenzied pace. In 2005, it launched 31 ETFs.
“AMVESCAP is an outstanding organization and an excellent fit for PowerShares. We are very excited about our future together,” says Bruce Bond, president and CEO of PowerShares Capital Management.
Notable ETFs that have attracted attention are the PowerShares LUX Nanotech (Amex: PXN), PowerShares Dynamic Oil & Gas (Amex: PXJ) and the PowerShares FTSE RAFI U.S. 1000 (NYSE: PRF). The latter index was developed by industry pioneer Rob Arnott, a vocal proponent of equally weighted stock indexes.
“The addition of PowerShares ETFs is a natural extension of our core mission to provide a broad range of investment management solutions to our diverse clients across the globe,” says Marty Flanagan, president and CEO of AMVESCAP.
AMVESCAP, which also owns the AIM lineup of mutual funds, will begin distributing PowerShares ETFs after regulatory matters have been finalized. Explaining its decision to buy PowerShares, the company cited ETFs as “one of the most compelling growth opportunities in the asset