Demand for next generation ETFs

Morgan Stanley estimates that worldwide, as of end November 2007, there were 1,137 ETFs with 1,847 listings, assets of $773.2 billion, managed by 73 managers on 42 exchanges. The US has the largest number of products and assets under management: 583 ETFs and $550.2 billion, followed by Europe with 412 ETFs and $134.8 billion and Japan with 15 ETFs and $35.3 billion. Worldwide ETF assets under management increased by 36.7% over the first three quarters of last year, which is greater than the 8.6% rise in the MSCI World benchmark in dollar terms.

Average daily trading volumes have increased significantly, according to Morgan Stanley data. By the end of last year, the worldwide 20-day average daily trading volumes in US dollar increased by 264.7% to $89.6 billion from $24.6 billion at year-end 2006. The range and diversity of product is also evident. An estimated 499 ETFs are expected to be launched through 2008: 51 in Europe, 390 in the US and 58 in the rest of the world.

ETFs were first introduced into Europe in 2000. The market grew as the appetite for diversification and the search for low cost alpha and beta increased. In the last two years assets under management in ETFs have doubled, and the number of ETFs has tripled. Since 2003 year on year growth in the sector has averaged at 40%, with growth from December 2006 to end 2007 topping 27%, according to db x-trackers, Deutsche Bank's Exchange Traded Fund Supermarket.

Thorsten Michalik, director of db x-trackers, comments: "The ETF market is still less mature in Europe than in the US and there is room for much more growth in the next 10 years. At present, we see demand for these products coming mostly from institutional investors; private wealth managers, pension funds and fund of fund managers.

"However, in the US in the last five years it is the retail investor who has taken to ETFs because they are cheap, efficient and flexible to use. Retail investors have yet to appreciate the benefits of ETFs in Europe, with the exception of Italy where 25% of all ETF sales are to retail investors. With the growing search for diversification and the growth of interest in assets such as commodities, we believe that European retail investors will begin to pay more attention to ETFs in 2008."

Deborah Fuhr, managing director at Morgan Stanley, says regulatory changes have allowed the development of new products. "The industry is evolving in a number of ways. Investors are looking for new sources of alpha but at the same time they have been disappointed that some of the promises from active managers have not been delivered."

"Not only did the returns not come through but, because they were actively managed, investors were being charged higher fees. So there is great interest in a low cost beta product, where if you get the asset allocation decisions right, you get out performance."

Seasoned players like Barclays Global Investors' unit iShares are now looking at the second generation of products. "The early adopters of ETFs in Europe were Germany and the UK," said Jennifer Grancio, managing director and head of distribution at iShares Europe.

"But now Italy, France and Scandinavia are showing very strong growth, both as a generalist tool for core investment managers and as a way to access markets where investors might be less confident about their stock picking abilities. ETFs are a very effective risk and diversification tool."

Emerging markets have so far been a great place for investors to shelter from the possible effects of the US sub-prime lending crisis, and so demand for related product has also grown, she added.

iShares, well established in the institutional market, is now weighing the broader applications of ETFs for the private and wealth management sectors. "There is a huge opportunity for private investors but there is a long way to go educating investors and advisers and setting up transparent and easy to deliver systems," said Grancio. "We have to have these conversations market by market across Europe."

She is also assessing how online access helps investors know and monitor the product. "That is how the industry started in the US, but institutional clients prefer different routes. We will remain in the institutional market but we want to explode in the wealth space. That means educating people on how to do business, how to get paid."

She anticipates a move away from a commission-based model to a fee-based one. "Innovation has to be sustained, there is a tendency to offer wraps, and there is increasing appetite for tailoring products for individual needs." iShares is launching more complex, bespoke products but the time to market is quicker as the sector infrastructure globally develops.

"We can go from concept to launch now in three months," she estimates. "For example we have just done an ETF on the global water market." In December, iShares launched three Shari'a-compliant ETFs on the London Stock Exchange.

As the market develops, ways of constructing indices become more sophisticated.

SPA ETF has linked up with MarketGrader in the US to construct indices using a sophisticated 24-factor stock evaluation system to evaluate US stocks. All the stocks in each basket have an equal weighting, and each MarketGrader index also undergoes a self-correcting rebalancing process to ensure holdings are of optimal grade. It is an objective system that takes emotion, over-reaction and bandwagon effects out of the investment decision making process.

"Stockpicking and indexing are normally seen as the antithesis of each other," explains James Oates, head of marketing for SPA ETF. "There is some debate about whether this kind of strategy is indexing at all, but this will be a moot point if investors are able to use these strategies to generate strong performance."