From the March 01, 2009 issue of Futures Magazine • Subscribe!

ETFs: Coming of age

If 2007 was the year that exchange-traded funds (ETFs) demonstrated they were major players in the financial arena, then 2008 was the year they came of age. Amid a persistent slide in equities, turmoil in interest rates, volatility in forex and massive swings in everything from crude oil to soybeans, ETFs remained in favor.

Although the ETF industry as a whole lost assets in 2008, as did investment sectors during a global financial contraction, the market for these relatively new vehicles remained solid. According to the Investment Company Institute, an association representing U.S. investment companies, U.S. ETFs had combined assets of $478 billion in November 2008. While that was down from November 2007’s $572 billion, it still represents an upward trend over time (see “Holding firm”).

A deeper look into the numbers suggests that ETF traders and investors are increasingly taking advantage of the further delineation of new listings. The drop in overall assets from November 2007 to November 2008 was predominately in global/international equity-type ETFs, to $100 billion from $175 billion. However, domestic sector/industry-type ETFs increased in assets, to $92 billion from $87 billion. ETFs continue to be a viable, and growing, means to exposure for specific sectors.

All that said, 2008 was a tough year. Several ETFs were delisted, and many more launches were delayed. For example, XShares Advisors liquidated a number of funds tied to the health services sector and real estate, and ETFs based on the Case-Shiller Housing Index did not launch as expected.

Still, the net number of listings increased (see “Holding firm”) and the average daily volume of ETFs made a significant jump, as indicated by the surge of ETFs making the cut this year for Futures’ ETF Guide.

Futures’ ETF Guide includes all ETFs that traded more than 100,000 units per day on average, the last quarter of the previous year. We had to raise the minimum from 50,000 to fit in the same space. For 2009, 362 ETFs traded 50,000 as opposed to 180 in 2008. While that’s partly a function of a net increase in ETFs listed, a far greater contributing factor has been the increase in volume. In 2009, the average daily volume of all ETFs listed in the guide was 6.5 million units, as opposed to 5.4 million last year.

INDUSTRY TRENDS

On an individual basis, the largest ETFs kept getting larger. The popular Standard & Poor’s Depository Receipts (SPDRs, pronounced “spiders,” which track the S&P 500) grew to almost 440 million units per day at the end of 2008 from roughly 225 million units per day at the end of 2007. The QQQQs (pronounced “Qs” or “cubes,” which track the Nasdaq 100) also experienced significant gains, leaping to 227 million units per day from about 180 million.

In a year of extended downtrends in both the stock market and, ultimately, commodities, it’s no surprise that bear-market ETFs, which gain value when the underlying drops in value, exploded. Based on last year’s 50,000 volume limit, Futures’ ETF Guide would have included nearly three times as many bear-market ETFs as last year. Among those, UltraShort funds, which are leveraged two-to-one, led the charge. The UltraShort S&P 500 ProShares (SDS) ETF was trading nearly 60 million units per day as 2008 came to a close. UltraShort ETFs tracking the Nasdaq, financial stocks, energy-linked stocks and real estate also were popular.

Commodity-linked ETFs are surging as well, with the top five funds averaging 22 million at the end of 2008 vs. eight million in 2007. This year, the top five commodity-linked ETFs are XLE, Ultra Oil & Gas ProShares (DIG), USO, SPDR Gold Shares (GLD) and XLB.

Other ETF categories, such as international and emerging-market ETFs and equity-sector ETFs grew significantly, while some, such as currency-linked ETFs and fixed-income related funds, experienced increased volumes.

While volumes were up, last year was one of contraction in an organizational sense. The New York Stock Exchange (NYSE) acquired the American Stock Exchange (Amex) and all Amex-listed ETFs moved to NYSE platforms. This effectively created one primary market for ETFs. Also in 2008, Nasdaq completed its acquisition of the Philadelphia Stock Exchange, as well as its active market in ETF options, renaming the exchange Nasdaq OMX Phlx.

In terms of product developments, the market continued to satisfy ETF traders’ and investors’ appetites for additional leverage. ProShares, which offers numerous leveraged ETFs under its “Ultra” listings, added several new ones in 2008, including both traditional and bear-market ETFs. These included leveraged long and short ETFs on the yen, the euro, crude oil stocks and telecommunications.

For those looking for even more, Direxion launched several three-times leveraged ETFs, designed to move 300% the change in the underlying. The Direxion 3X ETFs, which launched in November, proved quite successful, achieving average daily volumes of several million units per day by year-end. Long and short Direxion 3X ETFs are available on small-cap stocks, large-cap stocks, financial stocks, developed markets, technology and energy stocks.

Also, the era of actively managed ETFs officially began. Although the industry has attempted to launch these products for some time, they finally received regulatory clearance last year with several coming online. However, the products were not the instant success that many predicted, despite being cheaper and easier to trade intraday than mutual funds.

While ETFs lost assets in 2008, they arguably strengthened their standing relative to other investment and trading instruments. Indeed, in an environment where it would have been easy, if not mandatory, for the smart money to gravitate toward the familiar, ETFs proved to be innovative vehicles for managing risk and chasing reward, not a fad to abandon when uncertainty reigned. When less interesting times return, ETFs should be well positioned to benefit from the subsequent return of investment capital.

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