Getting to the bottom of ETFs

Pop quiz time. Name the investment securities that match these descriptions:

-Low-cost and flexible funds, reflecting a variety of market, industry and sector exposures, for buy-and-hold individual investors and advisers 

-Innovative institutional products that meet the requirement for a liquidity buffer, tactical and strategic asset allocation, portfolio rebalancing, tax-loss harvesting, sector rotation and investor anonymity

-Potential time bombs that could lead to another flash crash

-A witch’s brew created by and for market makers and hedge funds up to no good.

If you answered ‘exchange-traded funds’ (ETFs) for all the above, you’ve been paying attention to what’s being said about this relatively new and fast-growing asset class. So what’s all the fuss about? And – more importantly – why should IROs care?

The first ETF, the Standard & Poor’s Depositary Receipt, now the SPDR S&P 500, began trading 30 years ago. The first single-exchange ETF, the NASDAQ 100 Trust Series, launched with impeccable timing in 1999; with the ticker symbol QQQ, it was nicknamed ‘the cubes’.

The basket of the largest non-financial stocks on the tech-heavy NASDAQ more than doubled in price in its first year – coincidentally the last year of the tech bubble – before plummeting more than 80 percent over the next two and a half post-bubble years.

Staying power

That stomach-churning ride did not kill off ETFs, as some predicted, but it did capture the attention of both individual investors and the financial press while demonstrating the staying power of this emerging investment vehicle. 

The number of ETFs listed on US exchanges (more than 90 percent are listed on NYSE Arca) has ballooned from 90 funds with about $71 bn in assets in 2000 to nearly 1,500 with almost $1.5 tn in assets today.

On any given day, ETFs represent 30 percent to 45 percent of average daily volume on US exchanges. BlackRock’s iShares business holds more than 40 percent of ETF assets. Add in State Street, Vanguard and Invesco and the top four players control nearly 90 percent of the market. 

Originally the province of individuals and professional traders, ETFs are increasingly being used by institutions. Only 15 percent of all institutions use an ETF strategy, but they control 50 percent of all ETF assets, according to industry estimates.

And the category is poised to continue growing. BlackRock recently painted ‘an incredibly bright future’ for ETFs, predicting assets would top $3.5 tn in five years, driven by increased institutional and individual investor interest as well as continued development of more specialized ETFs. 

‘If you’re interested in who owns and trades your stock, ETFs matter to you,’ observed Chris Hempstead, director of the ETF execution business for WallachBeth Capital, a New York-based broker, speaking to IROs at NIRI’s annual conference earlier this year.

As the first NYSE specialist to trade QQQ, the 30-year industry veteran is even more bullish than BlackRock. He sees the market approaching $5 tn over the next five years.

‘It’s just the tip of the iceberg. We’ve only just started to discover how big this space is,’ Hempstead beamed. He said the growth in ETF assets will change the market in ways that have yet to be uncovered. ‘It will be a learning curve for all of us,’ he predicted. 

As registered investment advisers continue to gather assets from retiring baby-boomers, Hempstead sees them as ‘the new face of institutional investing.’ And as advisers seek to differentiate themselves with clients, he sees growing demand for more selective and actively managed ETFs, moving beyond the current passive index-dominated approach.

ETF tracking

So if ETFs double in size and dominate daily volume, how do you track who’s trading your stock and where, so you can answer that ubiquitous question: what’s going on with our stock today? 

While holdings within any specific ETF are pretty easy to track (see Further information, below right), as new funds continually get created and the criteria for inclusion become increasingly narrow and specialized, it’s becoming more complicated for IROs just to track which ETFs might even be including their stocks. As the ETF industry takes off, it looks like transparency will be a big challenge for issuers.

If you are a mid-cap stock and know your ticker is part of the S&P MidCap Index, for example, it’s pretty easy to figure out whether you are in ETFs built on that index, right? And both S&P and the ETF managers who shadow those indices are very transparent about which stocks are added and dropped in their annual rebalancing announcements, right? 

Actually, S&P has 11 separate indices built around mid-cap equities that are used to create ETFs, from growth, value, blended and low volatility to specialized indices built for clients such as Citigroup, according to ETF Database, an industry information source. And that’s not all. There are 36 separate ETFs focused on US mid-cap equities, with combined assets of $71 bn, tracking 41 separate mid-cap indices. So it gets complicated – and that’s just tracking the fairly well-defined criterion of market cap. 

Perhaps the best way to gauge the impact of ETFs on your stock is a blunt instrument. If you see a top ETF manager such as BlackRock or State Street significantly change its position over time, chances are that much of it is driven by the manager’s ETF holdings.

ETFs are being created and reconfigured to meet the growing demand for ‘innovative exposures’, as BlackRock puts it, for attributes such as lower volatility or specific duration. Indices are also being redesigned to enable managers to stay within market, industry sector or geographic investment guidelines while increasing exposure to specific subsets of stocks. 

For example, Standard & Poor’s and Robeco recently reconfigured the Dow Jones Sustainability Indices, based on Robeco’s Corporate Sustainability Assessment, into a more diversified and expanded set they branded the DJSI Diversified Indices. The new indices are designed to track performance ‘similar to standard global equity benchmarks, but with significantly greater representation to more sustainable companies,’ the joint announcement explains. 

Because these expanded indices are new, no ETF has yet launched based on them, but S&P says it is talking to several ETF managers and believes ‘there is a good degree of interest.’ This is an example of a potentially new family of ETFs where the criteria are not even built around something as definitive as market cap – so how would you know whether your company is included in one of these indices? It takes some digging.