US ETF Assets To Surge
Friday, July 15, 2011

Assets in Exchange-Traded Funds (ETFs) in the US are expected to double to USD2 trillion before the end of 2015, according to a new white paper from BNY Mellon and Strategic Insight.

First listed in the US in 1993, and in Europe in 2000, an ETF is an investment company with shares which trade intraday on stock exchanges at market-determined prices. Investors can buy and sell them in the same way as they currently trade in equities on an exchange. ETFs have become ever more popular due to their lower transactions costs and flexibility, and it was predicted by BlackRock earlier this year that global ETF assets would reach USD2 trillion by 2012. However, new research by BNY Mellon and Strategic Insight suggests that the US ETF market could be worth this figure alone in four years, driven by new asset classes, new indexes and new ways to use ETFs as tools for portfolio construction.

"The ever increasing sophistication of these newly created ETFs can pose operational and distribution challenges for asset managers. However, with detailed planning and a focused strategy, a variety of innovative exchange-traded products can be brought to market to effectively meet investors' needs," said Joseph Keenan, head of global exchange traded fund services at BNY Mellon Asset Servicing.

Traditional index-based ETFs are likely to account for a falling overall share of ETF assets as non-traditional and alternative funds grab a larger slice of the market, the research suggests. Since the end of 2008, non-traditional ETFs have grown from 18% of the market to an estimated 30% of US ETF assets by March 31, 2011, according to Strategic Insight's Simfund database. The BNY Mellon-Strategic Insight report predicts this trend will continue as investors become less likely to simply allocate their assets among growth stocks, value stocks, large cap stocks, small cap stocks and other traditional categories.

"Non-traditional ETFs will continue to increase their share of the ETF market," said Loren Fox, senior research analyst at Strategic Insight and an author of the report. "Commodity, leveraged, inverse, actively managed and hedge-fund-like ETFs are among the non-traditional ETF types that should see market share growth between now and 2016."

On the other hand, ETFs have been increasingly demonized by regulators over the last couple of years in the wake of the financial crisis because they lack transparency, while others have warned that the growing popularity of these instruments with retail investors is depriving companies of much needed equity investment at a time when the global economy remains fragile.

Last year, a report written by Harold Bradley and Robert Litan of the Kauffman Foundation argued that ETFs pose a serious threat to the growth of new companies and stock market stability in the future. ETFs are distorting markets to such an extent, they contended, that they are threatening the growth of new companies by effectively curtailing their access to capital.

“ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” said Bradley.

Litan added that, “in the process, ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges and, in turn, discouraging new companies from wanting to be listed on US exchanges.”

The report further documents that the proliferation of ETFs also poses systemic risks similar to those that were manifested during the “Flash Crash” in the US stock markets on May 6 this year. Without significant ETF-related reforms, the authors contend, more market instability is highly likely.

In April, the Basel-based Financial Stability Board, set up to coordinate at the international level the work of national financial authorities and international standard setting bodies, said that work is underway nationally and internationally to assess whether recent innovations and the related increase in complexity in some segments of the ETF market add to financial system risks and whether regulatory actions are needed to address potential shortcomings in the management of counterparty, collateral and liquidity risks, and in market transparency.