Despite a still-recovering economic environment,
exchange-traded funds (ETFs)– investment
funds traded on stock exchanges – have been one part of the
investment management industry that has continued to expand. There
were 233 new ETF product launches in 2010, up from
136 in 2009.
The types of ETFs have expanded as well, from the very simple, like the tech-heavy PowerShares QQQ, to the extremely innovative and complex, like convertible ETFs. With this product, convertible bonds can be exchanged for the issuer’s shares in some situations. They provide the safety of a bond as well as the potential returns of equities.
Today, there is increased awareness and utilization among end users and advisors alike. Increasingly, ETFs are used as building blocks of investment, and the products have multiple merits.
First is the high level of transparency. While mutual funds are only bought and sold at the end of the trading day, ETFs can be traded intraday – allowing them to be applied to a greater range of investment strategies.
Secondly, ETFs offer strong tax efficiency, as capital gain taxes are only realized on an ETF when the entire investment is sold. In comparison, a mutual fund, for example, incurs capital taxes every time the assets in the fund are sold.
Finally, although they have similarities to mutual funds, ETFs can be sold short, have lower costs and can be bought on margin.
ETFs represent “an efficient vehicle for investing in a particular asset or a portfolio of securities,” says Shundrawn A. Thomas, managing director, ETF Group, Northern Trust Global Investments. The cost effectiveness and flexible structure of ETFs provide exposure to a broader array of investments, including instances where the underlying asset is less liquid.
The U.S. credit crisis of 2008–2009 took its toll on ETFs. “The practical reality in that type of an environment is the need to focus on your clients and those areas where you already have an established base of business,” Thomas says. For Northern Trust, this meant that recently introduced ETF products were set aside to focus on its core asset management capabilities. The firm liquidated its Northern Exchange Traded Shares (NETS) in 2009 (see “Northern Trust’s Exchange-Traded Funds Group”).
But today, products like ETFs are getting a second look.
Awareness of ETF products continues to expand and is breeding
innovation in how investors implement their ETF
strategies. Market participants have become savvy with
products including United States Market Index ETFs, Foreign Market
Index ETFs, Foreign Currency ETFs, Sector and Industry ETFs,
Commodity ETFs, Derivative ETFs, Style ETFs, Bond ETFs,
Exchange-Traded Notes and Inverse ETFs.
In recent years, innovative uses of ETFs have included filling segment gaps in an equity portfolio, as part of a multi-asset investment strategy and as an element of a passively managed index-based investment strategy.
Recent regulatory changes also have improved confidence in the effective functioning of public securities markets, which has a spillover impact on ETFs.
Putting together the building blocks of the current post-crisis trading environment, the Securities and Exchange Commission (SEC) fine-tuned rules under which so-called “erroneous trades” would be canceled. In 2008, the SEC said it was concerned about the “possible unnecessary or artificial price movements based on unfounded rumors” regarding the stability of financial institutions and other issuers exacerbated by naked short selling (short selling a financial instrument without first borrowing the security) and the regulatory agency. That same year, it implemented more stringent rules on short selling that allow investors to handily short entire segments of the market as they use derivatives to deliver short exposure and leverage.
Then in September 2010, the SEC expanded the Circuit Breaker Pilot Program it implemented in June 2010 in an effort to prevent another “flash crash.” The program now includes all stocks in the Russell 1000 large-cap index and, specifically, almost 350 ETFs.
According to SEC rules, trading in a security included in the program is paused for a five-minute period if the security experiences a 10% price change over the preceding five minutes. The pause gives the markets an opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion. Where circuit breakers are not applicable, the exchanges and FINRA will break trades at specified levels for events involving multiple stocks, depending on how many stocks are involved.
The intent of the circuit breaker rules is to allow markets to attract new trading interest in affected securities and/or establish a reasonable market price when there is a significant dislocation in the market.
Because ETFs make up as much as a third of trading volume on any given day, regulators were compelled to include a number of actively traded ETFs in the Circuit Breaker Program, Thomas says.
A Time for Innovation
Awareness and innovative uses of ETF products will continue to increase. “As we survey the investment landscape, the growth of ETFs continues to outpace other investment vehicles and gains more share of fund flows from personal and institutional investors,” Thomas says.
As with mutual funds, ETF investing involves risk, including the loss of principal. Diversification may not protect against market risk.