TRILLION-DOLLAR ETF BOOM
Investor interest in exchange traded funds is snowballing, with global ETFs assets topping $US1 trillion for the first time– a milestone few thought would be achieved so fast. Product innovation, a desire for more transparent, low-cost products, and greater use of ETFs by financial advisers is driving growth. >Read more

TRILLION-DOLLAR ETF BOOM
Investor interest in exchange traded funds is snowballing, with global ETFs assets topping $US1 trillion for the first time– a milestone few thought would be achieved so fast. Product innovation, a desire for more transparent, low-cost products, and greater use of ETFs by financial advisers is driving growth.

The exchange traded fund (ETF) boom is accelerating, with new research showing global ETF assets have topped US$1 trillion. The ETF Landscape Industry Preview for December 2009 found worldwide ETF assets hit a record US$1.03 trillion in December 2009, up 5.1 per cent on November.

Appetite for ETFs grows
Global ETF assets have continued to grow despite the financial crisis. The rally in global equities markets from the March 2009 lows was significant. However, the 45.2 per cent growth in global ETF assets in the year to December beat the 27 per cent rise in the MSCI World index in US-dollar terms, iShares research shows. Over the past decade the compound annual growth rate of ETF assets globally was 56.3%, in the US it was 58.1% and Europe recorded 90.5%.

ETFs also grew strongly in Australia in 2009. The market capitalisation of ASX-listed ETFs topped $3 billion in December – up 185 per cent over 12 months – ASX research shows.

Deborah Fuhr, BlackRock’s Global Head of ETF Research, commented that “there are no signs that investor interest in ETFs is fading. Investors are finding that ETFs are products that work well in every market environment.”

Reasons for growth
And so they have. Several factors drove ETF growth. The first was a significant shift in investors’ risk appetite in the evaluation of counterparty risk and their desire for liquidity after the challenging market conditions of 2008. In 2009 many investors found that ETFs met their desire for greater transparency in relation to the issues of cost, transparency of holdings, liquidity and product structure.

Product innovation also supported growth. The number of ETFs globally rose 21.9 per cent in the year to December, with 423 ETFs launched and 80 closed. ETF issuers worldwide have plans to launch another 817 ETFs, according to iShares research.

Another important growth factor was greater understanding and acceptance by retail investors of ETFs as an important investment tool. The respected US publication, Barron’s, for example, described ETFs as “probably the most successful investment products in the past two decades”.

But comments by ETF expert Matt Hougan, of IndexUniverse, an independent US ETF website, that “Main Street still barely knows what they (ETFs) are” suggest significant growth is still ahead as ETFs increasingly become ‘mainstream’ investment and trading tools.

Arguably the biggest driver of ETF growth will come from financial advisers. In Australia, fee-for-service financial advisers are leading the way in recommending ETFs. They are following a similar trend in the US, with more advisers moving away from commission-based business models to fee-for-service operations.

Looking ahead
What of the next few years? Continued strong growth in the global ETF market seems likely as hundreds of new ETFs are listed and investor interest increases. This should result in more specialist research on ETFs to help advisers and investors. In addition, according to Deborah Fuhr, the global ETF market is expected to increase by 20% to 30% this year, as published in the latest ETF Landscape Industry Review of 2009.

From iShares
Click here to read the global press release “ETF asset reach US$1Trillion”.

The iShares website has a wealth of educational material for those new to ETFs.

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MARKETS: DEVELOPED OR EMERGING IN 2010?
By Tony Featherstone, Journalist
The case to invest more in developed nations is strengthening.

Moves by China to cool its economy contributed to a sell-off in global equities in late January and fuelled concerns that emerging markets are due for a significant correction. They also added urgency to the question: is it time to reduce exposure to emerging markets and re-weight portfolios towards advanced economies such as the United States?

This is an important question for investors in international markets. The iShares MSCI Emerging Markets ETF (ASX Code: IEM) returned 33 per cent in the year to December 31, 2009 in Australian-dollar terms. The iShares MSCI BRIC ETF (IBK) returned 47 per cent.

Gains in iShares ETFs over Western sharemarkets were considerably lower. The iShares S&P 500 ETF (IVV) returned minus 2 per cent in the year to December 31. The iShares S&P Europe 350 ETF (IEU) rose 4.11 per cent in the year to December. As with other unhedged investments, gains in the Australian dollar relative to the greenback and euro dampened 2009 Australian-dollar returns.

China still an impressive opportunity
At face value, China still looks a better opportunity than the US. China’s economy grew by 10.7 per cent in the 2009 December quarter, from a year earlier. This took full-year growth to 8.7 per cent – the Chinese Government predicted 8 per cent.

But double-digit growth is fuelling fears that asset bubbles are building and could burst if China’s economy overheats. This led to the People’s Bank of China curbing bank lending in January by requiring banks to hold more deposits.

The US has a different problem: the IMF forecasts economic growth of 2.7 per cent in 2010. Consumer spending, about two thirds of US economic activity, is struggling. High unemployment, weak bank lending and high debt levels could weigh on consumers for several years. Against that have been signs of labour market stabilisation and firmer industrial production.

Valuation discounts narrowing
Investors must decide whether these different economic prospects are fully reflected in Chinese and US equity valuations. The MSCI China index traded on a 2010 forward price-earnings (PE) ratio of 14 times at December 31, show consensus forecasts from Thomson Reuters. The MSCI USA index traded on 2010 forward PE of 14.5 times. The valuation gap between emerging markets and developed nations narrowed significantly last year.

Emerging markets historically trade at much larger valuation discounts to developed nations because of higher volatility. The average PE discount between emerging markets and developed nations has been 28 per cent since the mid-1990s, says Pennywise Investments. Some investors may see that as a sign emerging-market valuations have run too far.

The outlook
But relying on historical norms can pose problems. There is an argument that emerging economies such as China should be re-rated because of better economic management this decade, higher savings rates and stronger growth prospects.

Long-term prospects for emerging markets still look brighter than for developed nations, but it would not surprise if US markets outperform China in the second half of 2010 on expectations of stronger economic recovery. Expectations of a lower Australian dollar against the greenback add to the case to increase exposure to the US. A rising US equity market and falling Australian dollar would boost Australian-dollar returns in ETFs. Do not read these general ideas as a recommendation, but rather as a starting point for further research or discussion with your financial adviser.

About the author
Tony Featherstone is a former managing editor of BRW and Shares magazines. He is the consulting editor for the ASX Investor Update e-newsletter, and iShares ETFinvestor.

From iShares
The iShares Fund Fact Sheet Booklet has details on all 19 iShares ETFs.

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ADVISER Q&A: TOP ETF STRATEGIES
iShares
ETFinvestor spoke to Geoff Stewart, Associate Director and Senior Investment Analyst at Macquarie Private Wealth, and a leading portfolio management analyst, about the growth of ETFs.

ETFinvestor
Geoff, what are the main benefits of ETFs?

Geoff Stewart
The biggest benefit is choice. ETFs have created a larger investment universe, or ‘opportunity set’. Investors can use ETFs to gain exposure to asset classes that may have been hard or expensive to access. Combined with better access to portfolio software, ETF growth should lead to a significant change in investor portfolio-management strategies over time.

ETFinvestor
What changes do you see?

Geoff Stewart
Retail investors and financial advisers will increasingly think like institutional investors when constructing and managing portfolios. They will use ETFs to take more of a ‘top-down’ country or sector view that complements ‘bottom-up’ stock or fund selections. And they will think more carefully about the allocation of fee and risk budgets within portfolios.

ETFinvestor
How do ETFs help with fee and risk budgets?

Geoff Stewart
Institutional investors and high-end retail clients we deal with know the allocation of fees and risk has a significant impact on long-term portfolio returns. Low-cost ETFs help investors better allocate their portfolio fee budget. ETFs can also allocate risk more efficiently. For example, an ETF over emerging markets historically is more volatile than an ETF over the S&P 500 index in the United States. Sound portfolio construction is about getting the ‘biggest bang for your buck’ by spreading volatility.

ETFinvestor
What strategies do you favour with ETFs?

Geoff Stewart
We like three broad approaches. The first is a ‘core and satellite’ approach where investors take a core or semi-permanent position in certain markets using a basket of ETFs. This may include a long-term position in emerging markets using ETFs that provide an ongoing cost advantage. The second approach is flipping that core and satellite strategy around. Here, investors include active funds in the portfolio core and use ETFs in the satellites. For example, an investor may have active funds that invest in advanced economies in the core, and ETFs over emerging markets in the satellites. The third approach is a tactical strategy where investors use ETFs to take advantage of shorter-term opportunities and trade ‘top-down’ research strategies. This could involve rotating out of emerging markets into advanced economies as a tactical trade this year.

ETFinvestor
What specific ideas do you favour?

Geoff Stewart
We have had a structural overweight position towards emerging markets in our diversified asset class portfolio for some time, a view that worked well for our clients. We believe emerging markets will continue to provide higher returns markets than advanced economies in the long term. From a dynamic or tactical point of view, United States sharemarkets should continue to improve in the next 12 months as investors anticipate a stronger US economic recovery.

ETFinvestor
What is your currency view?

Geoff Stewart
Our currency strategists believe parity between the Australian and United States dollars is unlikely in the short term. More likely is the Australian dollar will retreat to the mid-US80 cent level by year’s end as expectations firm of US interest rate rises. If this happens, Australian investors could use ETFs to benefit from a pick-up in US equities and a lower Australian dollar relative to the greenback. After such strong gains in Australian equities and currency in 2009, the case to increase portfolio allocations to the US in 2010 is strengthening.

From iShares
Learn more about these investment techniques by reading the Core/Satellite Investing Case Study.

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EDUCATION: SUPER ETF STRATEGIES
iShares
Why more self managed super funds are embracing ETFs

Exchange traded funds (ETFs) are playing an increasingly larger role in self managed super funds (SMSFs) as more investors use low-cost index products to take control of their superannuation.

SMSFs held the largest proportion of super assets at September 2009, accounting for about $369 billion – or 30.9 per cent – of the total $1.195 trillion in retirement savings, Australian Prudential Regulation Authority’s (APRA) latest Quarterly Superannuation Report shows. Australian Tax Office data, published on the ATO website, shows more than 400,000 SMSFs had almost 800,000 members in June 2009.

As SMSFs have grown, so has interest in listed index funds such as ETFs, which invest in a basket of securities to replicate an underlying index. ETFs are ideally suited to SMSFs because of their low management expense ratios, transparency, flexibility and diversification benefits.

Using ETFs within SMSFs is also more popular after the global financial crisis, with more investors motivated to manage their own superannuation.

APRA’s working paper, Investment Performance Ranking of Superannuation Firms, published in June 2009, looked at 115 Australian superannuation firms between 2002 and 2006, It found that “on average, value adding from active management appears statistically to be unable to overcome higher costs associated with attempts to exploit market inefficiencies”. Of course, choosing the right active fund that outperforms its index can add significant value, a reason why many investors blend active and index funds such as ETFs in their SMSF. The APRA paper also said: “The inability of investors to reliably compare individual funds or investment options … together with inadequate fund disclosures … had led to a form of market failure, where given the necessary resources many investors may chose to minimise their dependence on the managed fund market. This may explain the recent rapid growth of self managed super funds to become the largest superannuation sector in Australia.”

The importance of fees
Fees are an important consideration in all portfolios. Fees for iShares ETFs range from 0.09 per cent to 0.82 per cent. Those for retail managed funds may be as high as 2 per cent. ETFs also involve brokerage charges, but these may be small for SMSFs that take a ‘set and forget’ approach and hold assets for many years. Lower fees with ETFs can make a huge difference to long-term SMSF returns.

Another advantage of ETFs over unlisted index funds is greater portfolio flexibility. Investors can build passive portfolios using detailed components such as ETFs over specific emerging markets. Unlisted indexes are typically based on much broader sharemarket indices, which make it harder for SMSF investors to get exposure to specific country or sector opportunities. SMSF investors can also use ETFs to rebalance their portfolios to maintain core asset weightings.

Also, ETFs generally do not distribute unrealised capital gains among investors, as unit trusts do, therefore avoiding unexpected capital gains tax bills.

SMSF investors are increasingly blending ETFs and active managed funds, and shares, in portfolios. They may have an indexed core in their portfolio that holds ETFs over sharemarket indices in advanced and emerging markets. Investors then ‘bolt on’ active managed funds to the portfolio core for more tactical asset allocation in areas such as fixed interest, property or alternative investments.

From iShares
For a full list of iShares ETFs available on the ASX detailing fees, view the iShares Product List.

To find out how to buy iShares, click here.

Management costs: Total fund management fees and expenses as a percentage of average net assets, and is equivalent in calculation to the indirect cost ratio (ICR) and the management expense ratio (MER).

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