Opportunities abound as ETFs expand to cover the the world.
Looking for direct access to commodities markets
including gold and oil? Want to short real estate or buy international
value and growth? Or are micro-cap stocks or Malaysia more your cup of
tea? Until recently, access to many of these asset classes was
prohibitively expensive or complicated. But ETFs have changed all of
Let's take a quick asset class by asset class journey through the frontiers of ETF innovation. I'll discuss the gloomy pre-ETF world for each asset class, and then move from asset classes that are already covered by ETFs, asset classes expected to soon have U.S.-trading ETFs and asset classes which could eventually have ETFs of their own.
Single Countries And Regions
ETFs have been covering single countries almost as long as there have been ETFs. Originally launched back in 1996, the WEBs (now iShares) were really the first mutual funds that enabled investors to directly access the wild and wooly world of individual country volatility, in nations from Austria to Singapore.
As an interesting sidelight, an ETF that often has been presented as the bad boy of ETFs, the Malaysia iShares, actually demonstrates exactly why ETFs work so well. Back in 1998, if you'll recall, there was a crisis in Asia; at one point, Malaysia stopped all equity trading and was not allowing money to leave the country. Really, in terms of Malaysia, the ETF was the only game in town, and that ETF was trading at enormous discounts and premiums to the actual value of the underlying stocks. Of course, the irony is that there really wasn't much going on with the underlying shares. And in terms of capital, the ETF was actually used by some market watchers as a proxy for the currency market (which had been officially frozen). So the ETF did its job, trading at the perceived market value of the underlying equity portfolio.
Since the days of the individual country WEBs, the ETF market has met and surpassed the ability of traditional mutual funds to meet the clamor for broadly diversified international investments, and has done it at generally much lower cost. U.S.-trading ETFs now cover MSCI EAFE, as well as emerging markets funds and other European, Asian, Latin American regions and global sectors. If you want it, internationally, it now pretty much exists. The last remaining gaps (which I've often heard from DFA aficionados) of international style and size in ETFs are already in the first stages of being addressed, in the form of the new iShares EAFE growth and value funds.
Styles And Sectors
In terms of the U.S. market, it's hard to imagine more comprehensive coverage of size, style and sector asset classes. But ETF providers are trying. Now, with a micro-cap ETF (ZAK) available from PowerShares (and more probably on the way), every permutation of growth, value, core, large, medium, small and every market sector has been launched as an ETF many times over.
Just be careful what you're buying. The array of indexes from Standard & Poor's, Russell, Dow Jones and Morningstar are all over the map in terms of how they define growth and value, market capitalization and sectors. This choice can be a good thing, if you know how to use it. But it can also lay waste to a portfolio with overlap and underexposure if implemented improperly.
Gold products have been the most prominent recent entrant in the world of ETFs. The immediately soaring asset base (nearly $3 billion invested in just a few months) of SSgA's streetTRACKS Gold Shares (GLD), and later the iShares COMEX Gold Trust (IAU), clearly are a testament to previously unmet investor demand for direct, inexpensive access to gold bullion.
Previously, virtually all the products on the market were either indirect (funds of mining company stocks), expensive (it's not cheap OR efficient to buy the yellow stuff directly) or not accessible to smaller investors (the futures markets). Now investors have a direct, easy-to-understand means of buying a direct interest in actual bars of gold that are sitting in a vault. Shares in both ETFs trade at 1/10th the value of one troy ounce of gold (a share of GLD or IAU currently trades at around $40). Both funds have a fee of 40 basis points, far less than precious metals mining company equity funds, with their attendant company risks and noncorrelation to gold bullion prices. iShares, by the way, also has filed with the SEC to launch a silver ETF.
Next up, oil. Already, an oil ETF has been launched in the U.K. (London's gold ETF also beat the U.S. products to market; Australia was first.) Oil presents a somewhat stickier problem than gold, because it is not really practical to store oil in mutual fund company tanks. From the start it was clear that an oil ETF would have to be based on derivatives, namely futures. And trading ETFs, themselves financial derivatives based on other financial derivatives, seemed even a short time ago an unthinkable notion. But it was not imagined, even 15 years ago, that mutual funds might one day trade like stocks. Times, of course, change.
It does appear that even in the U.S., with its complex web of regulatory authorities, the ETFs based on futures nut will be cracked in the not-too-distant future. An oil ETF has already been filed for, and even more tellingly, Barclays Global Investors (BGI) has already filed with the SEC for a more diversified commodities ETF that would track the Goldman Sachs Commodities Index (GSCI). And when BGI files for a new ETF, it's a good bet that they already have had extensive talks with the SEC and are confident in their ability to bring the product to market.
The oil ETF could be a very hot product for obvious reasons; the GSCI iShare would opening up what might legitimately be called a new asset class to noninstitutional investors. I know I've been throwing that term "asset class" around a bit loosely, but the very low historical correlations to the equities markets (not to mention very strong recent performance) could make this a very appealing addition to a portfolio.
Already in registration is an exciting new ETF that will allow investors to directly play currency markets-and earn interest on the money to boot. Rydex, already with a reputation as an index innovator responsible for the Equal-Weighted S&P 500 (RSP) ETF, has teamed up with some of the most experienced ETF innovators in the business (including some of the same people who brought GLD to market) to file with the SEC to launch a euro-based ETF.
Although euro shares as yet are the only currency products in registration at the SEC, more will come tied to other currencies. Such ETFs will provide investors with direct exposure not only to the currency, but also to the interest rates in the relevant market-these ETFs will effectively act as money market funds in the relevant region or country. So, given the fact that historically half of the correlation benefit of international equities is based on currency rate differences, when you add interest earnings to these products they could be an interesting portfolio addition.
Actively Managed ETFs, Leveraged ETFs, Hedge Fund ETFs
Semiactive ETFs already are on the market, namely those launched by PowerShares. These ETFs essentially attempt to outperform "the market" by using quantitative methodology that aims to add alpha over the returns of bogey indexes like the Nasdaq 100 and S&P 500. They do still track fully transparent indexes, but they are proprietary, alpha-seeking indexes. Since launched, in any case, these funds have performed exceptionally well.
The next logical step is the one that some industry observers think could change the fund world as you know it-actively managed ETFs. Fidelity, that most active of mutual fund managers, is already dipping its toes into the ETF business with its Nasdaq Composite ETF (ONEQ). Time will tell if a large segment of the actively managed mutual fund market moves in this direction. First, we've got to get one to market.
Leveraged ETFs are supposedly on the way from ProFunds, and all indications are that these could be very nice niche products that would enable investors to leverage indexes (Nasdaq 100 X 2, for example) or go long to short (inverse Nasdaq 100) in real time. It seems like these funds have been in registration with the SEC for an eternity. But my guess is that if and when they do come out, they could do quite well, particularly if the markets are being feisty.
Finally, hedge funds are certainly a logical place for ETFs to be. With all the attention cast on hedge funds, and all the new indexes built to track the market, plenty of people would love to see hedge fund ETFs. But as with actively managed ETFs, there are transparency issues to overcome; in addition, because hedge fund investors must now be qualified, wealthy investors, opening them to the retail market would require any product to jump through some serious regulatory hoops.
Really, with the forthcoming launch of ETFs based on futures, the sky is the limit in terms of where ETFs could go. Interest rate or GDP plays? Local housing market swaps? The best is yet to come.
Jim Wiandt is president of Index Publications LLC, editor of the Journal of Indexes and publisher of IndexUniverse.com and Exchange-Traded Funds Report.