 | The following article is an excerpt from Steven Schoenfeld's recently released book, Active Index Investing , published by John Wiley & Sons. More information about the book can be found at www.activeindexinvesting.com |
Indexing In 2005 And Beyond
As Yogi Berra famously said, "One should never forecast, especially about the future.' But in the concluding chapter of my recently published book, I felt it important to take a 'big picture' view of the future of indexing, and thus I'll take the risk of being wrong in my projections for the industry. This article includes predictions about not only index product development, but also about asset growth and market share for index funds and ETFs. These predictions might seem bold now, but I believe strongly in the continued growth potential of index products and, notwithstanding the revolutionary achievements that indexing has brought to investing since its development in the early 1970s, the revolution has really just begun .
As we move deeper into the fourth decade of indexing and the second decade of ETFs, one can clearly identify three broad trends that will drive the continued growth and use of index-based products. First , intense product development will continue, with innovation, competition (and consolidation) and expansion of asset class coverage. Second , ETF use will broaden, and they will become standard tools for almost all financial market participants. Finally , the financial industry will seamlessly utilize index products, especially ETFs, as a component of other financial products, whether within (active or enhanced index) funds, within separate accounts or in blends of ETFs and derivatives.
Worldwide Index Product Development
While the past ten years have seen tremendous strides made in index-based and ETF product development, I believe that we are just at the cusp of even greater innovation. Fixed-income ETFs have been listed in the U.S only since mid-2002, and yet their growth has been dramatic ¾ in asset gathering and trading activity ¾ with more fixed-income products steadily on the way. The same can be expected for fixed income in Europe .
In the major developed markets, product innovation will likely fall in four broad areas:
• (1) filling out the asset classes with index products;
• (2) continued twists on index-based ETFs with "quasi-active" products;
• (3) the move toward "pure active" ETFs; and
• (4) the continued listing of derivatives on ETFs.
In the filling out the asset classes category, there remain some asset class niches and key countries and regions that are still hard to get exposure to with exchange-traded products. However, it is becoming clear that ETF manufacturers will no longer let their products cross-subsidize each other for the sake of a 'complete' product set/index family. The 2003 closure of three families of sector funds in Europe demonstrates this. It has been stated by many in the industry that "all the good indexes are taken.' While this is true to a point, it is clear that markets evolve and there will be newly popular asset classes that emerge, and indexes ¾ and the ETFs that track them ¾ will continue to be launched.
Regarding newer asset classes, commodities likely will provide a promising area for development. Gold ETFs trading in Australia and the U.K. have proven popular, and their launch in the U.S. (along with proposed silver ETFs) could prove very popular with both retail and institutional investors, especially if they make holding the yellow (and silver) metal more efficient. As we've seen with the rapid growth of the iShares MSCI emerging market ETFs in 2001-2003, when products ease the market accessibility of an asset class investors often move substantial assets into these products, even if the expense ratio is relatively high.
Derivatives use within an ETF structure will also be a vital element within the leveraged and inverse ETFs that are awaiting exemption from the SEC. After the first launch, it is very likely that other firms will use the same exemptions to launch a myriad of ETFs with derivative-linked exposures. An open question for these types of products, which will only be answered after launch, is whether the market will utilize these specialized ETFs in the same way that investors use the mutual funds that facilitate market timing.
If derivative-based ETFs are accepted in a major way, it would open up the path for other potentially valuable new products based on risks that are currently traded primarily in the over-the-counter market ¾ risks and variables like weather, hydrocarbon emissions, housing prices, economic statistics, etc. If futures markets develop for some of these risks, products that address individual and corporate liability streams could be created. This could eventually lead to liability-based products that solve total end-user needs (which I discuss at the end of this essay). Also falling into the more esoteric category is the concept of an ETF structure for either a hedge fund 'fund of funds' or a hedge fund index fund . One such open-end mutual fund has already been launched, and more could be on their way.
The first 'pure active" ETFs will likely have some element that is index-based ¾ either a 'core' index component from which the creation/redemption mechanism takes place, or through a sector rotation or multi-asset class rotation approach, where index-based subcomponents are actively managed. The reasonably good success enjoyed by the first of what I call "quasi-active" ETFs (the original PowerShares funds, the RYDEX Equal Weighted S&P 500 ETF and the iShares Dow Jones Select Dividend Index fund) indicates that there would be market acceptance for such products, and the recent filing by PowerShares for more than a dozen new "quasi-active" ETFs highlights potential interest. But first, the tough 'nut' of developing a pure active ETF will need to be cracked ¾ and approved by the U.S. Securities and Exchange Commission. This is essentially the challenge of maintaining a robust creation/redemption mechanism to ensure that the market price is aligned with the ETFs' NAV, while preserving a reasonable level of opacity to shield/hide the managers' alpha-seeking positions. If, but more likely when, this nut is cracked, we could see a massive shift of active funds to the ETF structure due to its greater efficiency.
In smaller developed markets, and in emerging markets, we can expect to see product development follow many of the patterns we've seen in major developed markets, but with a faster 'take off.' As this essay is being written, there are ETFs in six emerging markets and they are in development in at least four others, including China , which only launched its first index fund in 2003.
As product development steadily continues around the world, investors' "tool kit" of ETFs and derivatives on ETFs will essentially be complete. Thus the key to further growth will be a deepening and broadening of usage by an expanding group of intermediaries and end-users.
Expansion Of Index Product Usage
As index funds and ETFs become more embedded into the financial "tool kit" of investors, their use has expanded dramatically. Major broker/dealers in the U.S., Europe and Asia have established dedicated sales/research teams to service the growing institutional users of ETFs, and they increasingly have been integrated with other index-based research and trading operations. These sell-side groups serve pension funds, mutual funds, institutional asset managers and hedge funds. A number of internally managed pension funds, which would never hire external index managers, will gladly use ETFs for exposure to both U.S. and domestic markets. Even major pension funds that extensively use external managers will use ETFs for cash-equitization and asset allocation/rebalancing. Standard 'institutional-like' strategy/manager allocation approaches have become much more accepted by financial advisors. Hedge funds have increased their use of ETFs and derivatives on ETFs substantially. Table,1, below, lists five of the most common applications of ETFs that are driving this expansion of usage.
Furthermore, a number of significant recent developments have spurred usage, most notably the easing of restrictions on mutual funds in the U.S. and Europe to include ETFs in their funds. While the number of institutions using ETFs in the U.S. and Europe in mid-2003 was already impressive at over 1,300, it can safely be predicted that this number will be closer to 5,000 by the end of the decade. There is no reason why the majority of mutual funds should not use ETFs for their cash equitization and asset allocation needs.
Another major development has been the controversy and legal action regarding mutual fund sales practices and timed trading. Significant outflows can be expected from impacted mutual fund families, and index mutual funds and ETFs will likely gain significant assets from investors seeking transparency, low cost and lower risk.
As promised, I have some bold predictions for the growth of indexing, especially regarding ETFs. I would be surprised if total worldwide ETF (and related products) assets were less than $1 trillion by the end of the decade. This figure is still less than a quarter of the current size of the U.S. mutual fund industry, although the controversy over mutual fund sales and trading practices could shrink mutual fund assets and further accelerate the growth of ETFs. Similarly, I would expect that retail-oriented index mutual funds, which currently account for more than 16 % of U.S. mutual fund assets , will achieve a penetration rate that closer to the 25% or more ratio common amongst institutional investors. The late-2003 scandals involving traditional mutual fund sales and trading practices will likely be a major impetus for investors to move assets to index mutual funds, which already had seen substantial net inflows throughout the bear market of the early 2000s. . Therefore, depending on overall equity and bond market levels, it is possible that total index mutual fund assets in the U.S. could approach $2 trillion by the end of the decade. When combined with the ETF projections above, the aggregate of publicly available index-based funds could be close to $3 trillion by end-2010.
Hybrid Products
One of the factors that will drive asset growth is the acceleration of 'hybrid products,' namely, financial products that seamlessly blend ETFs and other securities and/or products. For example, more and more financial advisors will be providing their clients with total financial accounts that seamlessly blend separately-managed accounts, mutual funds and ETFs (Citigroup's Smith Barney Consulting Group unit is in the forefront of this development, with the 2003 rollout of their "Integrated Investment Services" platform for their in-house brokers).
Another way that ETFs are being integrated into other structures is through privately managed accounts, whether via trust banks or the more common separately managed account products offered through financial advisors. Several firms have introduced index-based separate accounts, which track benchmark indexes such as the S&P 500 and the Russell 3000. One such strategy can track a large-cap U.S. or international benchmark with just 50 to 60 securities, and hold a certain percentage of the relevant ETF in lieu of cash and to minimize tracking error. We can expect to see more extensive use of ETFs within separate accounts in the coming years.
Just as the original financial product to include an ETF structure ¾ LOR's SuperTrust ¾ included a risk-control vehicle (the different SuperShares that provided different claims to performance of the Index SuperUnit), investors can now use combinations of ETFs and options/futures on ETFs to construct a virtually infinite variety of return/risk patterns. These structures, which can be assembled into "modified beta portfolios ," provide investors with a great deal of flexibility in hedging their portfolio to reduce risk.
Particularly in the early to mid-2000s, as equity and fixed-income market direction has been volatile and uncertain, there is strong appeal for using a combination of ETFs and their related derivatives to customize exposure and provide protection from extreme market moves. The range of strategies is essentially limitless, but can be broken into four basic areas, which are highlighted in Table 2, below.
Option overwriting is well understood in the industry, but in the past, index option overwriting was limited to the most well known 'flagship' indexes. With the advent of options on ETFs, the range of underlying indexes available for this strategy has expanded dramatically, and we can anticipate that by mid-decade almost all of the key ETFs will have related options trading. In addition to the more familiar 'buy-write' strategies, since ETFs can be shorted on a downtick, Put overwrite strategies are also practical. These strategies are for relatively bearish investors who do not believe a market/sector/style will completely crash.
The 'infinite flexibility' provided by ETFs and their derivatives is undoubtedly a major positive development for the capital markets and financial services industry. But in some ways, this myriad of options ( pun intended ) is way too much choice for the average end-user. Most investors don't want infinite flexibility ¾ they want solutions tailored to their own needs. While 'mass customization' is an overused phrase, it is the direction in which our industry is heading, and ETFs and their derivatives will provide some of the capabilities for these solutions to be developed.
Indexing In 2010
By the start of the next decade, indexing will be a much more known and accepted strategy than currently. While that might sound silly ¾ how could indexing get more well known than it already is? ¾ you must remember that your perspective is skewed. You are reading an index-focused publication, and therefore you're likely to be much more informed than the average financial market participant (I'm not pandering ¾ I mean it). I've already made asset level predictions, so I won't repeat them. It is better to be wrong only once, but I do stand by them.
By 2010 the complete tool kit of ETFs and their derivatives will be established, and users might be overwhelmed by the variety of products. But lest one thinks that financial market innovation will be static in 2010, in many ways the growth and proliferation of ETFs will still be just one component of an even broader tool kit of financial products that enables our industry to reach its real potential.
The most intense financial innovation will be needed to solve the real needs of households, pension funds and foundations/endowments, corporations and governments. As expounded by leading financial academics like Merton Miller, Robert Shiller and others, the most pressing need for financial products is for the ones our industry has not yet developed . What end-users of financial products really want is not more and more choice of products, but solutions that solve their functional needs. For example, individuals have major lifetime income streams and needs ¾ salary, inheritances, college tuition, health care, retirement ¾ and there is no reason that our industry cannot develop indexes, and products based on these indexes, to fully solve individuals' long-term financial needs.
There is no reason that financial engineering cannot produce efficient products linked to macroeconomic variables and microeconomic factors such as household expenses (baskets of goods) and risks (insurance like products). The resulting products may look like variants of structured notes, or a modified ETF vehicle (it would not be surprising if they had some similarities to the predecessors of ETFs, the Americus Trust and LOR's SuperTrust). Whatever structure, these functional products have enormous potential for management of lifetime personal risks and expenditures, and more predictable financial planning for millions of people.
As such products are developed, index-based funds, ETFs and their related index derivatives are likely to play a key role ¾ as core holdings in lifetime portfolios, as hedges for liabilities and as building blocks for structures that we cannot fully imagine yet. Systems and financial technology will inevitably play a key role; it is highly likely that the assembly of highly customized portfolios of securities, funds and ETFs, and perhaps even derivatives, will be constructed by model-driven, proposal/portfolio builder systems using optimizers and other models. An advisor or individual should be able to plug in a variety of risk parameters, customization factorsand the need, and the custom portfolio is built. Numerous firms are working on pieces of these future 'solution set' functionalities ¾ it is no longer a question of whether they'll be introduced, but rather when they'll be available.
Playing A Part In The Revolution
Penetration of indexing within institutional portfolios is likely to be relatively static for U.S. domestic assets (as the growth curve shifts to enhanced indexing). It likely will continue to grow, however, for international indexing, both standard and enhanced, particularly as the "arithmetic of active management" asserts itself on traditional active approaches with the application of more appropriate and better-constructed benchmarks. Outside of the U.S. , there is much room for further penetration of indexing in Japan , Asia, parts of Europe and in almost all of the advanced emerging markets.
OK, I can't resist a repeat of my prediction, but now with a more global perspective. As stated earlier, a conservative estimate of the overall ETF asset base in 2010 would assume at least 20% of the current U.S. mutual fund market, and a substantial slice of both retail and institutional assets in Europe and Asia . Thus I would be surprised if global ETF assets were less than $1 trillion in 2010, and I believe it is much more likely that they'll be closer to $2 trillion. When combined with index mutual funds in the U.S., U.S. tax-exempt institutional index strategies, and international institutional index strategies ¾ users such as Japan's Pension Fund Association (PFA) and Singapore's Government Investment Corporation (GSIC) ¾ my estimate for 2010 total worldwide indexed assets is over $7 trillion. By my 'guesstimate' (this is a multifaceted estimate, which means it's only slightly better than a guess) would represent at least 15% of total world equity market capitalization in 2010 .
Innovation in all dimensions of investment theory, technology and business practice will lead to continued growth in indexing. I envision two parallel revolutions: The aforementioned institutional paradigm shift toward separation of beta and alpha will drive steady demand for low-cost efficient market exposure. There is no better provider than index-based strategies, and they'll be available for every asset class ¾ and many quasi-asset classes such as hedge funds strategies.
An even larger retail/individual investor revolution is brewing. While starting well behind the institutional curve, this marketplace is steadily catching up. The financial advisor community is slowly but surely adapting a core-satellite approach. This is a huge step forward from the industry's traditional 'portfolio of expensive, underperforming active managers' that has been skewered in my book and in countless academic papers, and I believe that recent disclosures about mutual fund practices will accelerate this progress.
Individual professionals working in the marketplace still will make a difference. Almost every financial market player will have opportunities to participate in this investment product and strategy revolution. The industry will provide the tools ¾ robust indexes based on every imaginable asset class and economic factor that evolve with market developments, liquid products based on those indexes, and their derivatives. Academia will provide many of the key theories and formulae for new structures, and will supplement the players in the marketplace.
But every financial professional can work to provide for the functional needs of their clients ¾ whether it is income and retirement security, health care or appropriate hedges for long-term liabilities. Every individual investor can benefit by following the Four Key Axioms of long-term investment success and placing "indexing at the core" of their portfolios. With both professionals and individuals taking more responsibility for their investment performance, the future of indexing ¾ index funds, enhanced indexing, ETFs, index derivatives and alternative asset indexing ¾ is indeed bright. The revolution that started a third of a decade ago has truly just begun!
The article is an excerpt from Chapter 31 of Steven Schoenfeld's recently released book, Active Index Investing , published by John Wiley & Sons. The complete chapter includes more detailed predictions and descriptions of potential future trends in index product development and usage. More information on the book can be found at www.activeindexinvesting.com
1. For an overview of the theory, history and impact of indexing, see Part One of Active Index Investing , especially Chapters 1 and 2, as well as the book's forward, written by Don Phillips of Morningstar.
2. Chapters 10 and 22 of Active Index Investing highlight some of the changes in the fixed income market dynamics that ETF and ETF derivative trading has begun to unleash. Unfortunately, it will take another book, and perhaps another author!
3. The most dramatic example of this is with the iShares MSCI Emerging Market Fund ¾ 'EEM' ¾ which tracks the primary benchmark for the entire asset class. It was launched in early April 2003. By November 2003 it had grown to $600 million in assets, and by it's one year anniversary had close to $1.5 billion in assets.
4. For more on commodity indexes see the sidebar within Chapter 10 of Active Index Investing .
5. There is currently more than $12 billion in the combined RYDEX, ProFunds and Potomac fund families, all of which facilitate market timing and feature numerous leveraged and inverse products.
6. This concept is not as far-fetched as it may sound. RYDEX Capital launched at 1940 Act Fund tracking the S&P Hedge Fund Index in 2003, and by mid-2004 it had attracted more than $250 million in assets.
7. Korea , Taiwan , India , Israel and South Africa . See stories on indexing in Brazil , ETFs in Israel and China 's first index fund on http://www.indexuniverse.com/
8. For updates on the mutual fund market timing and sales practice issues, as well as updates on U.S. and global ETF assets, see http://www.indexuniverse.com/
9. The first such firm was Active Index Advisors, which launched its range of products in early 2003. The author of this article spearheaded the building of several of these portfolios during that time.
10. For a complete description of the SuperTrust structure, and the subcomponents that are combined to implement various risk-controlled investment strategies, see Exhibit 4 of the Harvard Business School Case Study, cited in Chapter 31 of the book.
11. An up-to-date list of ETFs with listed options can be procured from most brokers, or on exchange and or ETF issuer sites. Such a list is also provided by several exchanges on http://www.indexuniverse.com/.
12. A good explanation of the Put Overwrite strategy with ETFs is provided in "ETFs - An Alternative to Futures and a Companion to Options" by Murali Ramaswami and Alex Bundy in A Guide to Exchange Traded Funds, edited by Brian Bruce (Institutional Investor 2001) page 159
13. See Shiller, Robert J., The New Financial Order , Princeton University Press, 2003.
14. See Schoenfeld, Steven A., " Watch Out, Active Managers, for the new EAFE" in Pensions and Investments, November 12, 2001 , page 12.
15. 'Advanced Emerging Market" - like Active Index Investing - is decidedly not an oxymoron. Not only is it a formal country classification in the FTSE Global Indexes, but equally important, it recognizes the steady progress of developing countries that pursue the appropriate economic liberalization and democratization policies. Previous members of this category, such as Portugal and Greece , have since graduated to developed market status, and many of the current members ¾ South Korea , Taiwan , South Africa , Israel , Mexico and Brazil ¾ are likely to follow the same path.
16. First of all, I recognize that indexing would be in fixed income and other asset classes as well, but solid numbers outside of equities are pretty hard to come by. I estimated world market capitalization in 2010 by taking the end-2002 figure of just under $24 trillion (according to S&P's 2003 Global Stock Markets Factbook), adding 2003's market move, and smoothing an extrapolation from the average of m-cap levels from the previous five years. This gets to a range of $35 to $40 trillion in 2010, so my guesstimate of 15% is very much on the conservative side.
17. These key axioms are outlined in Chapter 30, "Indexing at the Core," of Active Index Investing.
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2004
