Investors are turning to ETFs as uncertain times continue

WHEN American private equity firm Blackrock recently acquired Barclays Global Investors in a deal worth $13.5bn it was seen as a smart move by some industry analysts, largely because of BGI&rsquo;s involvement in the exchange-traded-funds (ETFs) industry through its &pound;375bn iShares business.<br /><br />ETFs have been big in the US for many years, and the financial crisis has shown European investors &ndash; both institutional and private &ndash; the benefits of investing through ETFs when there are wild swings in the markets and companies are suffering. <br /><br />ETFs are passively-managed vehicles which track an underlying asset or index and are traded on an exchange, which means that they have to be very transparent and reflect the composition of the underlying index. This is proving a popular mix and the ETF sector has continued to attract inflows while in the rest of the fund management industry, outflows have soared and assets under management have plummeted. <br /><br /><strong>NEW LAUNCHES</strong><br />Globally, $775.20bn of assets are under management in ETFs, of which only $151.4bn comes from European ETFs. But that number is growing. From the start of 2009 until the end of April, assets rose 9 per cent, the number of ETFs increased by 4.3 per cent and there are currently plans to launch 767 new ETFs, according to research by Deborah Fuhr, global head of ETF research &amp; implementation strategy at BGI.<br /><br />Nicholas Brooks, head of research and investment strategy at ETF Securities, which provides ETFs, says that this is due to a change in investors&rsquo; attitudes towards trading following the financial crisis. &ldquo;Investors&rsquo; minds have been very much focused on liquidity and on relative performance, while retail investors in particular are wanting to cut their costs,&rdquo; he says. ETFs fit the bill.<br /><br />And providers are targeting the retail investor as the source of future growth in the industry. Lyxor Asset Management is expecting the retail sector to be one of the fastest growing segments, tracking what has happened in the US.<br /><br /><strong>ACCELERATED GROWTH</strong><br />The recent abnormal market conditions have accelerated the growth of interest in ETFs. Because they are transparent, investors know exactly what they are getting themselves in for when they buy or sell an ETF, making them well suited to volatile markets. With the majority of ETFs you get automatic diversification in just one trade, which cuts the costs of trading and reduces your exposure to risk. This is much cheaper than either composing an investment portfolio yourself or paying the fees of an actively-managed fund. <br /><br />Eleanor Hope-Bell, head of wealth at iShares, says that another attraction of ETFs is that they are highly liquid, meaning that it is much easier for investors to get in and out of their positions, even in tight market conditions. &ldquo;Their fund nature means that if there&rsquo;s not enough liquidity in the secondary market then you can slip into the primary market. There are multiple market-makers who will go out and buy the underlying constituents of the fund and will then give the provider those securities to release onto the market,&rdquo; she explains, adding that you don&rsquo;t necessarily have these two sources of liquidity with an index-tracker fund. <br /><br />The ETF industry is now big enough to look at ETF flows as an indicator of current sentiment, says Dan Draper, global head of Lyxor ETFs, although he cautions that it does not necessarily have a predictive value. He says that retail investors tend to stick to buying ETFs of the FTSE 100 or the FTSE All Share but institutional clients are trying to load up on beta &ndash; which measures the volatility of a security in comparison to the market as a whole and can be used to calculate the expected return of an asset.<br /><br />But with 701 ETFs in Europe with 1,826 listings, there is plenty of choice. So, what is popular now? Earlier this year, all the big providers saw a spike in interest in fixed income ETFs &ndash; both government and corporate bonds &ndash; because of the lack of risk appetite. However, Draper says that Lyxor saw some big redemptions in fixed income ETFs in May and in early June because people started worrying about rising inflation and so moved into equities.<br /><br />The growth in risk appetite has meant there has been a big pick-up in institutional interest in ETFs of emerging market indices, especially the BRIC countries (Brazil, Russia, India and China). <br /><br />Sectoral ETFs also exist and Draper says that market volatility is directing many sophisticated investors towards ETFs in European banks. Some are even considering cyclical sectors such as consumer discretionary and industrial sector ETFs.<br /><br /><strong>POPULAR COMMODITIES</strong><br />ETFs&rsquo; sister asset class, exchange-traded-commodities (ETCs &ndash; together they are known as ETPs, Exchange Traded Products), has also been extremely popular in 2009. ETF Securities&rsquo; two physical gold tracker ETCs, which are the biggest in Europe, have seen about &pound;2bn of inflows since November last year because of the uncertainty about volatility and what governments are doing by ramping up debt levels.<br /><br />Crude oil is the other popular commodity and the collapse in prices during the second half of 2008 attracted plenty of buyer interest in ETFs as well as in the futures markets. Since the start of 2009, ETF Securities says there has been inflow of $1.3bn into its oil ETFs, reflecting investors&rsquo; anticipation of a pick-up in global demand. <br /><br />ETF Securities has also seen a very strong growth in flows into its natural gas and agriculture ETFs &ndash; agriculture tends to have a very low correlation to the business cycle, so it is a great diversifier when market direction is uncertain. <br /><br />Some market commentators have argued recently that ETFs have not had a great success rate in tracking the underlying index over the longer-term. Yet this tends to apply to the more complex derivative-based and leveraged ETFs rather than the straightforward ones that are popular among retail investors. Like any financial products, ETFs have their disadvantages, but the European ETF industry is growing rapidly as private investors look for transparent, cost effective and liquid products with which to gain exposure to the rapidly moving markets. Their time seems to have arrived.