Exchange traded funds enjoyed a banner year in 2006. Assets under management soared, especially in Europe, and there was an explosion of new offerings covering an array of different sectors,
geographical locations, styles and strategies. The momentum is expected to continue through 2007 with providers churning out a steady crop of products over the coming months.

According to Morgan Stanley's magnum opus on the exchange-traded industry, Year End 2006 Review, globally the tally at end-2006 was 732 ETFs with assets under management of $573bn (€423bn). The US, where the product was first launched in 1993, boasted the highest number, at 343, with assets under management of $406bn. Europe is second with 272 ETFs at $89bn followed with Japan, with 13 and $34.6bn.

Looking ahead, Debbie Fuhr, managing director investment strategies, and the author of the 2006 Morgan Stanley report, estimates that ETF assets under management could exceed $2trn by 2011. The main drivers are that investors are not only more familiar with the ETF concept, but regulators in the US and Europe have relaxed restrictions placed on investing in the product. Europe's cause will be especially helped by the Undertakings for Collective Investment in Transferable Securities (UCITS III) directive, which has significantly raised the amount a fund can invest in other UCITs funds and UCITs ETFs.

"There has been tremendous growth in the ETF market, particularly in Europe where assets under management grew by 60% - the largest rise ever," says Isabelle Bourcier, ETF global co-ordinator of Lyxor AM, the asset management arm of Générale Corporate and Investment Banking. "This is being fuelled by the liquidity in the market as well as the growing product range. Also, investors are better educated and are using ETFs for a broader range of reasons. They are no longer merely a product that tracks an index but a tool in an asset allocation strategy."

While institutional investors still mainly use ETFs to equitise cash, they are increasingly employing them as part of a core-satellite strategy, whereby a chunk of the portfolio is placed in largely passive or low tracking error instruments such as ETFs. They are also turning to the product to achieve extra yield and greater diversification.

"Investors are looking at ETFs in a much more sophisticated way and are moving to the next level. They are using them more for tactical allocations," says Lars Hamich, managing director of STOXX. "They are looking closer at their risk/return profiles and instead of focusing on stock selection, they are using ETFs to take underweight and overweight positions."

The past year has seen a dazzling array of new products tracking almost every conceivable index and catering to every investment need. The most popular were in the alternative investment space with a spate of launches in the illiquid asset arenas of private equity, real estate and infrastructure. For example, Barclays Global Investors' iShares launched the first infrastructure fund in the US and Europe, and a family of real estate ETFs that provide exposure to property and real estate investment trusts in Asia, the US and the UK, in addition to its long-established European property fund.


merging markets were also a favourite, with all major providers trying to outdo each other with an ever-longer list of products covering regions and countries. "Emerging market ETFs will continue to be popular because they provide exposure to new geographical regions as well as countries such as China, Russia and India that are not that open to foreign investment," says Danièle Tohmé-Adet, co-head of the EasyETF platform at BNP Paribas Asset Management.

Commodities and to a lesser extent currencies have also entered the ETF frame. In fact, four of the largest ETFs to hit the market in 2006 were based on commodities in the US, with the biggest, iShares Silver Trust, amassing $1.8bn in assets. In Europe, ETF Securities made a splash last September, launching 29 separate exchange traded commodities on the London Stock Exchange, comprising 19 individual securities and 10 index securities, although these are not actually ETFs (see p 76).

"Commodities used to be an alternative investment, but due to the development of global capital markets and new financial products that provide simple market access, commodities are becoming widely accepted as mainstream," says Graham Tuckwell, chairman of ETF Securities, which now has $1.2bn of AUM. "Our funds are based on total return swaps that provide commodity exposure. In the past if investors wanted to buy commodities, they had to buy futures which some funds could not do due to restrictions in their investment policies."

Although short/long strategies have not yet gained traction in Europe, investors are looking at ‘covered call' products. Last year, Lyxor launched an ETF on the Dow Jones Euro Stoxx 50 Buy-Write Index, Europe's first pan-European buy-write index. It combines equal holdings of the Dow Jones Euro Stoxx 50 Index and a Dow Jones Euro Stoxx 50 call option, and any necessary adjustments are made on a monthly basis. The main objectives are to minimise the risks during bearish market phases and increase potential returns in sideways trend and moderately bullish markets, according to Bourcier.

The market is also buzzing with ETFs that track clean water, energy and biotechnology. "The industry began with the more mainstream asset classes, regions and countries and now it is moving into more esoteric products," says John Davies, senior director of S&P Index Services. "Fund managers are looking much more at dynamic asset allocation and products that generate alpha. The industry will continue to develop and we will see more products such as fundamental tracking where the underlying indices are being tweaked."

Fundamental indices eschew the traditional method of reflecting shifts in share prices and market capitalisations. These new styled indices, such as the FTSE Group Rafi series which made its debut in late 2005, are based on the fundamentals of turnover, dividends, free cash flow and book value. It is a small but growing area, with Lyxor recently launching four ETFs on Euronext linked to the FTSE Rafi while last year BGI unveiled an ETF based on Dow Jones Euro Stoxx Select Dividend 30 index.


Despite the hoopla, it is important to note that equities still rule and that it will take time before the more exotic products gain traction. According to a study conducted last year by French based Edhec Risk and Asset Management Research Centre, 61% of current or planned participants used equity ETFs while the figure for bond ETFs was 26%.

Fixed income in general has been relatively unchartered territory, with BGI being the only sponsor offering ETFs in this area. In 2002, it introduced funds tracking US Treasuries of varying maturities, investment-grade corporate bonds and a broad investment-grade bond index. This year, the company is set to provide the ‘building blocks' for fixed income in Europe, with a set of ETFs tracking government and corporate bonds in Europe and the UK, according to Jennifer Grancio, head of distribution at iShares Europe. Despite its size and dominance in Europe, BGI is not complacent. The firm usurped Lyxor's pole position after acquiring third-ranked player Indexchange last November. It now has a weighty 50% of the market while the French contender has 25%.

Jennifer Grancio, head of distribution at iShares Europe, says: "The deal with Indexchange has given us scale to have a local presence across Europe. We are investing in educating European investors who do not use ETFs, not only through acquisitions but also in opening local offices and listing products on six local exchanges. New players are entering the market such as investment banks and specialists. In the future there will more consolidation - particularly at the smaller end of the market," says Grancio.

"In today's environment, it is important to be innovative, have all the solutions in all the boxes and provide a full suite of products," notes Greg Ehret, senior managing director of State Street Global Advisers, which is relabelling all its ETF products under the SPDRs umbrella. "Europe is also a different market in that there is more duplication of products on indices than in the US. As a result, it is also important to differentiate yourself though marketing and branding."