And Now, Perhaps, a Pause

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The number of exchange-traded products listed on U.S. exchanges quadrupled between 2004 and 2008. Stand by for a slowdown.

By Greg Newton

More than 850 exchange-traded funds (ETFs) and notes (ETNs) were listed on U.S. exchanges at the end of 2008 — about 160, or almost 25% more than in December 2007. But while that's impressive growth by any standard, it concealed several clear indicators that the market's dramatic expansion, from less than 200 exchange-traded product listings in 2004, was slowing abruptly:

Most of 2008's new listings occurred in the first half of the year; the pace slowed as the year wore on and financial markets were roiled by the multiple impacts of the credit crisis.

The number of new listings in 2008 was down from a record of around 270 set in 2007.
And, either ominously or mercifully, depending on one's perspective, almost 60 ETFs were shuttered during 2008.

The funds that died shared a number of features apart from their failure to attract sufficient investor interest. All were managed by second-tier vendors. Many were in narrow market segments (the 19-member HealthShares family of health-care-related ETFs accounted for almost one-third of the closures). Others, such as the Elements currency ETNs, the Adelante family of real estate ETFs and the Ameristock-Ryan U.S. Treasury funds, were latecomers to already competitive sectors. Investment banking debacles took out Lehman Brothers' Opta ETNs and the first actively managed ETF, the Bear Stearns Current Yield Fund.

The pruning has continued into 2009, with Northern Trust closing its 17 NETS ETFs on February 9. Introduced during 2008, the NETS family offered country funds, most based on the performance of the local benchmark — for example, the FTSE-100 for the U.K. — instead of the MSCI index followed by the well-established iShares country funds. In another time, and a different market environment, they might have survived and even prospered, although it is unlikely that they would have seriously challenged the iShares hegemony.

Not now. With just $33 million in total assets, or an average of less than $2 million in each fund, their "inability...to attract significant market interest, their future viability and prospects for growth in the foreseeable future" resulted in a board decision "that it was advisable and in the best interests of the funds and their shareholders" to liquidate the funds, according to the closure announcement.

While the number of new ETFs and ETNs will likely decline dramatically in 2009, products introduced in late 2008 and so far in 2009 hint at trends that will probably show among future introductions.

The NETS closures outnumbered the 11 new ETFs listed in January 2009, supporting a growing consensus view that ETF and ETN listings may actually decline in 2009, although the final outcome will probably depend on overall market performance. At most risk are the same type of products that were hit in 2008: small funds that have failed to gain traction, whether for poor performance, their similarity to better-established products or a simple failure to attract attention in an increasingly crowded market.

Market declines in 2008 also produced the first ever significant loss in total ETF assets, which stood at $530 billion at year-end, down $90 billion, or 15%, according to former Morgan Stanley analyst Paul Mazzilli, now senior advisor at Index IQ. Still, in the face of a 37% decline in the S&P 500 and a 43% loss in the global ex-US MSCI EAFE index, more than $175 billion flowed into U.S.-listed ETFs, according to Mazzilli.

Hints of Product Trends

While the number of new ETFs and ETNs will likely decline dramatically in 2009, products introduced in late 2008 and so far in 2009 hint at trends that will probably show among future introductions.

Active management: The first actively managed ETFs came to market in 2008. Pioneer Invesco PowerShares added the Active U.S. Real Estate Fund (PSR) to its lineup in late 2008 and plans to introduce two new funds focused on non-agency residential mortgage-backed securities. Founder Bruce Bond says that the ETFs, which will be managed by Invesco's institutional asset managers, aim to benefit from government actions to stabilize credit markets.

Bond subscribes to the view, supported by more than a few experienced managers of distressed assets, that credit market dislocations have pushed the prices of many Prime and Alt-A RMBS well below their "real" value, and that ETFs are an appropriate vehicle to provide both liquidity and transparency in those market while allowing investors to benefit from the opportunities. No date has yet been announced for the release of those ETFs.

Other providers, including some newcomers to the ETF market, have also announced plans for actively managed equity-based funds.

Fixed income: Building on the fixed-income theme, four of the 11 ETFs introduced in January — two from Barclays Global Investors' iShares, and two from State Street's SPDR family — offered new options covering sovereign bonds and U.S. agency mortgage-backed securities. Other providers have also introduced a wide range of other fixed-income ETFs, covering Treasury, municipal and corporate offerings with different duration and risk structures, many within the last 18 months or so.

Filling the gaps: It's getting harder to find gaps in ETFs' equity market coverage, but products covering airlines and the countries of Colombia and Indonesia have shown up already this year.

New instruments: Last year's record stock market volatility meant that a lot more people are aware of the Chicago Board Options Exchange's VIX, the so-called "fear gauge" measuring the implied volatility of S&P 500 index options over the next 30 days. Barclays' iPath ETN unit introduced the S&P 500 VIX Short-Term Futures (VXX) and Mid-Term Futures (VXZ) products in January 2009.

Gold: Many Ways to Play

While ETF proliferation has its critics, it has unquestionably widened, and in many ways simplified, options for individuals looking to implement investment themes. Until late 2004, investing in gold usually meant buying coins and paying the wide spreads charged by dealers; buying individual gold stocks or gold-oriented mutual funds; or, less often, taking a futures market position.

That changed in late 2004 when what is now the SPDR Gold Shares (GLD), representing one-tenth of an ounce of gold, came to market as the first, and certainly the most successful, commodity ETF. By Jan. 31 2008, its assets had grown to more than $25 billion. The virtually identical iShares Comex Gold ETF (IAU) was launched in January 2005, and its assets have since grown to around $2 billion. Both funds charge an annual expense ratio of 0.40% and usually trade within pennies of each other.

A third choice for the investor seeking a simple gold position is the PowerShares DB Gold Fund (DGL), which, instead of being backed by physical gold, is based on gold futures contracts and is intended to track the Optimum Yield Gold Excess Return component of the Deutsche Bank Liquid Commodity Index.

Both GLD and IAU returned around 5% in 2008; DGL made 1.8%.

Deutsche Bank also launched the first levered and inverse gold-based ETNs in February 2008. The three funds the PowerShares DB Gold Double Long ETN (DGP), Gold Short ETN (DGZ) and Gold Double Short ETN (DZZ) are based on the same index as DGL, but as their names imply, aim to deliver respectively double, inverse and double-inverse returns. ProShares also launched the double-long Ultra Gold (UGL) and double-short UltraShort Gold (GLL) ETFs in December 2008.

The ETF equivalent of the traditional equity mutual fund is the Market Vectors Gold Miners ETF (GDX), which has been listed since May 2006. The fund holds more than 30 companies, but is relatively concentrated: Barrick Gold (ABX), Goldcorp Inc (GG) and Newmont Mining (NEM) account for more than 30% of its holdings, and the ten largest holdings account for more than 60% of the portfolio.

Unsurprisingly, given the stock market ructions in 2008, GDX had a rough year compared with the actual metal. It lost 26%, but finished the year more than 40% off its March 2008 high.

Still, a crowded runway

Despite the uncertainties confronting asset classes of all kinds, one certainty for 2009 is that regardless of how many ETFs and ETNs are shuffled off the stage, investors will be offered more ways to play more investment theses. According to IndexUniverse, 497 ETFs were moving through the U.S. Securities and Exchange Commission at the end of January, meaning another surge of new products is likely once markets normalize.

Investing in ETFs and ETNs involves risks similar to those with any exchange-listed investment, including possible losses. Shares are not FDIC insured, may lose value and have no bank guarantee. Before investing in ETFs and ETNs, investors should carefully review available documents, including risk disclosures and other disclaimers included in the products' prospectuses, and assess their suitability for their own financial circumstances.