What was bad news for the stock market this year may prove to be good news for ETFs in 2009. As the financial markets reeled, some freshman funds that debuted in the last year, many of them commodity, currency and leveraged/inverse offerings, gave investors an alternative to business-as-usual stock and bond investments that couldn't seem to find a bottom.
New product introductions and the increasing popularity of ETFs covering alternative investments filled some of the gap left by falling stock prices and solidified these funds as investment staples rather than niche products. Assets in inverse/leveraged ETFs saw the biggest jump, increasing by 106% from the beginning of the year through the third quarter, to nearly $20 billion. Introduced about two years ago, leveraged ETFs seek to provide a multiple of the daily return of a particular index, while inverse ETFs try to replicate the inverse of an index and are typically used as a hedge. Investors looking to ride the bear market using hedge portfolios have been flocking to these products, and of the ten most heavily traded ETFs in September, three were ultra-short funds offering an inverse index return.
Assets in commodity ETFs (and ETNs) increased by 28% through September, while those in currency products increased 33% and those in fixed-income products rose 43%. SPDR Gold Shares is now the third-largest ETF in the country, having drawn net inflows of close to $3 billion in September alone, and is also one of the largest holders of gold bullion in the world.
The popularity of these new products points to a broader shift in thinking about traditional asset allocation strategies. "Until recently, most people didn't have the time or expertise needed to gain exposure to anything beyond traditional equities or fixed income," says ETF specialist Tom Lydon, president of Global Trends Investments. "Now that it's easier to diversify into alternative investments, people are shifting away from old-line asset allocation models and exploring other options."
At the end of September, 704 U.S. ETFs with assets totaling approximately $580 billion were available according to State Street Global Advisors, representing a decrease of 4.6% from asset levels at the beginning of 2008. While this marked the first time that ETF assets fell from the previous year, the drop could have been much larger considering the severe bear market during this period. The trading volume of ETFs and ETNs continued to grow, reaching 35% of all equity trading in September, according to National Stock Exchange data.
Actively managed funds, those monitored and managed by professional investors that don't track indexes, made their debut this year. The WisdomTree Dreyfus China Yuan, one of eight currency income funds, was launched in May and now has about $255 million under management, making it the largest actively managed ETF. The WisdomTree funds invest mainly in non-U.S. money market securities and offer yields that reflect foreign money market rates as well as exposure to foreign currencies. In total, WisdomTree's eight currency income ETFs (which are based on the U.S. dollar, the euro, the Brazilian real, the Japanese yen, the Chinese Yuan, the Indian rupee, the South African rand and the New Zealand dollar) have nearly $400 million in combined assets.
Still, the industry is suffering growing pains. By mid-October, 41 ETFs had closed this year as a crowded market eliminated the weaker contenders, while several "core" ETF strategies, such as international, global, dividend-focused and all-cap value and large-cap growth, experienced large drops in performance and assets.
The much-anticipated introduction of actively managed funds has proved to be a mixed bag. Amid the controversy surrounding its excessive exposure to subprime mortgage debt, Bear Stearns launched the first actively managed ETF in March, the Bear Stearns Current Yield ETF (YYY), with little fanfare, and the fund stopped trading in September. In mid-April, PowerShares Capital Management launched four actively managed ETFs, but so far, the funds have collected only a few million dollars in assets.
The roster of fixed-income ETFs expanded dramatically this year to 51 offerings with nearly $50 billion in assets, compared with only a handful two years ago. But bond ETFs came under scrutiny later in the year as credit market disruption and other factors caused their net asset values to diverge from underlying bond prices, in some cases by 15% or more. Instead of tracking indexes, as many investors expected, these funds began looking more like closed-end funds with wide discounts or premiums to net asset value.
The credit risk inherent in exchange-traded notes, a lesser-known sibling of ETFs whose returns typically track commodities or currencies, also came into focus. Instead of being backed by assets, as ETFs usually are, these notes are unsecured debt that mimics the performance of a particular index.