The State Of The ETF Market
By Cliff Weber, Gary Gastineau, Gus Sauter, John Jacobs, Jim Ross, Lisa Dallmer

The ETF market is changing … fast. More than 300 ETFs launched last year in the U.S. alone, and an additional 450+ are in registration. Assets are growing at a 40+ percent annual clip, and the types of investors using ETFs are evolving as well.

Meanwhile, the traditional specialist-driven market maker system—a system that has supported the growth of ETFs since the first one launched in 1993—is rapidly disappearing. And two of the biggest ETF listing venues in the world—the New York Stock Exchange and the American Stock Exchange—are merging.

Against this backdrop, Matt Hougan, senior editor of the Journal of Indexes, spoke with six leaders of the ETF industry to see how and where this fast-moving industry is evolving.

Cliff Weber, executive vice president of development and strategy, American Stock Exchange

Journal of Indexes (JoI): Do specialists have a role in the future of ETFs?

Cliff Weber, American Stock Exchange (Weber):
I think there certainly will be a role for liquidity providers. What we are seeing in the markets, and what has been happening for some time, is a convergence of the traditional specialist role and the traditional market maker role towards a ''designated liquidity provider'' model. In this model, the liquidity provider is directly compensated for liquidity provision at an enhanced rate in return for commitments on continuity and quality of markets. This is driven, at least in part, by the deterioration in the value of being a specialist post-Reg NMS [National Market System] and by the desire of the issuers to have someone committed to supporting their fund in the secondary market.

JoI: Has the shrinking size of seed capital had an impact on newly listed ETFs?

Weber: Since ETFs can be created and redeemed each day at NAV [net asset value], there really shouldn't be a material impact on the market quality or attractiveness of an ETF as a result of the amount of seed capital. To the extent that a specialist or market maker is sitting on more inventory than desired, he or she may be willing to be a more aggressive seller, but that isn't likely to continue for too long. I think at the end of the day, the real issue is that many of the more recently listed ETFs are based on more narrowly focused market segments or strategies, so they naturally have a smaller universe of interested investors. Also, it is becoming harder for the newer ETFs to get attention as the number of new ETFs continues to grow so dramatically.

JoI: Should investors worry about spreads for active ETFs when they launch?

Weber: Investors always should worry about spreads in any investment, including index-based ETFs, as spreads directly impact return on their investment. There are a number of ways investors can manage that cost, including the use of limit orders inside the bid and offer instead of market orders.

In this context, though, I think the real question is whether or not one can expect spreads systematically to be wider in actively managed ETFs than in index-based ETFs. A lot of this depends on the specifics of the funds you are comparing, but all things being equal, to the extent there is less certainty in the exact holdings of the fund, the spread is likely to be wider. Therefore, the more the fund manager is willing to disclose about his holdings, the narrower the spread is likely to be. However, our experience has been that most traditional active managers don't want to reveal much, if any, information beyond their current practices.

To compensate for this, we have developed an approach where additional information is provided to the marketplace to serve as a proxy for the fund holdings and performance without revealing the actual fund holdings. This information will help narrow the spread. How much the spread narrows will have to be seen in the market once trading begins, but we have done a lot of testing on this with many funds and our results have been very encouraging.

JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Weber: ETF listings provide a number of benefits. Issuers pay listing fees, but these tend to be rather minimal in ETFs. Also, the exchange may provide some services in connection with the listing, but again, these fees tend to be modest. The real benefit for an exchange is that the primary listing venue tends to have a material market share edge in trading versus products listed on other markets and traded UTP [unlisted trading privileges]. This advantage translates into more opportunity to earn transaction-based fees and fees from the sale of market data.

JoI: What will the ETF market look like five years from now?

Weber: Over the past five years, the ETF universe has exploded. The number of ETFs in the U.S. has grown from 130 to 646; the number of domestic issuers has increased from five to 23; assets under management have increased from $101.6 billion to $620.5 billion. [These numbers compare the end of 2002 with the end of 2007.] This growth has been fueled by the increasing awareness and acceptance of the ETF structure, the expansion of the product category to include new asset classes like commodities, and the extension of the product into narrower subsegments of the market and into more strategy-based and theme-based indexes.

I think the next significant trend that will drive ETF growth will be the introduction of true active management into the ETF structure. ETFs ultimately are a very flexible and efficient distribution platform. The successful extension of this platform to truly actively managed portfolios will open the category up to the many, many investment managers that currently do not issue ETF shares because they don't run index funds and don't want to disclose their funds' holdings. The net result will be a much broader base of issuers. And while I don't expect that many of these new funds will be very active traders, I'm quite sure that once these funds are available, smart investors will create new and innovative ways to use them for alpha capture strategies, etc.

Gary Gastineau, managing director, ETF Consultants

JoI: Do specialists have a role in the future of ETFs?

Gary Gastineau, ETF Consultants (Gastineau): I think market makers in new, less actively traded ETFs will be supported by fund issuers. Issuers will find that they must subsidize market makers, at least in the period immediately after the launch of a fund. There are a number of mechanisms for doing this, and additional ones will probably be developed over time.

The role of the specialist or any other market maker is usually less significant for ETF investors (or traders in any security) when a security trades more than a million shares a day than when it trades a few thousand shares a day. The structure and economics of the NMS make it inevitable that computerized trading engines attempting to capture tape revenue by trading in size for little or no net transaction profit will continue to increase the disparity in trading volume between more actively and less actively traded ETFs.

It is interesting to note that ETF trading volume in the U.S. has been running over 1 billion shares a day. The volume has been very concentrated: ETFs trading over a million shares a day account for 95 percent of total volume. The average assets of these actively traded ETFs is about 10 times the average assets of the less actively traded funds, but the average trading volume of the most actively traded funds is more than 100 times the volume of the less actively traded ETFs. There is a good chance that the four most actively traded ''stocks'' for 2008 could all be ETFs.

JoI: Has the shrinking size of seed capital had an impact on newly listed ETFs?

Gastineau: Willingness of market makers to contribute seed capital is a function of the amount they expect to make by trading an ETF. The growing disparity between trading volumes in the most and least actively traded ETFs is partly a function of a crowded marketplace, where getting attention is difficult. As in the case of subsidizing market makers, issuers of new ETFs will have to be more creative in looking for seed capital.

It is interesting that very little attention has ever been paid to the modest size of small mutual funds as a cause for concern, but a great deal of attention is paid to the assets of small ETFs. As long as expenses are capped, small fund size is not very important. A fund that has grown too large is much more likely to face performance problems than a fund that remains small is to face viability problems. The performance problems may be easier to hide, but they are more costly to investors.

JoI: Should investors worry about spreads for active ETFs when they launch?

Gastineau: Trading spreads will be narrower for less actively traded funds with a more investor-oriented trading mechanism. Trading spreads will stop being an issue.

JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Gastineau: Frankly, I have never understood this phenomenon.

JoI: What will the ETF market look like five years from now?

Gastineau: Actively managed ETFs will be well on their way to surpassing transparent index ETFs in terms of assets under management. Benchmark index ETFs will continue to dominate trading activity for as long as I can imagine. The evaluation of funds will be much more sophisticated and the nature and quality of fund information will be greatly improved. Within five years it should be clear to everyone that the ETF structure can be vastly superior to the mutual fund structure for all investors—including participants in defined contribution plans and other investors who make small periodic investments in funds.

Gus Sauter, chief investment officer, Vanguard

JoI: Do specialists have a role in the future of ETFs?

Gus Sauter, Vanguard (Sauter): I certainly think they do. Whether it's under the name ''specialist'' or ''lead market maker'' or just ''market maker,'' I think they will certainly have a role in creating liquidity for ETFs … as they have historically. Of course, as certain ETFs become more liquid, a lot of the market is made by the investors themselves, and that reduces the role of specialists in those funds. But I do think that they will have a role in creating a market for ETFs.

JoI: Has the shrinking size of seed capital had an impact on newly listed ETFs?

Sauter: I think it certainly has. I also think there will be a lot of ETFs that will not even make it to market because they won't be able raise seed capital. These are ETFs that are pretty narrow in scope and don't have much investor appeal. So, yes, there will be and has been an impact.

JoI: Should investors worry about spreads for active ETFs when they launch?

Sauter: Certainly they should be concerned about spreads. They represent a cost of investing; it's a form of transaction costs. In an index ETF, you should typically have reasonably small spreads. In an active ETF, they will undoubtedly be much wider, reflecting the risk of uncertainty to the market maker or specialist. They don't have the same degree of certainty or knowledge of the portfolio, so they are going to widen the spreads. I think many people underestimate transaction costs, and spreads are a key component— they can wipe out any expected return from the investment.

JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Sauter: Certainly, the exchanges benefit from fees paid on any securities that list there. There's also a transaction fee that they receive for trading, so the exchanges love to have products that have a lot of volume—they receive a small transaction fee for every single trade. That is one of the primary sources of their revenues.

JoI: What do you consider when deciding where to list funds?

Sauter: We look for three things, not necessarily in this order: 1) we consider the exchange's commitment to the ETF marketplace, 2) we look at the reliability of the exchange, and 3) we look at the amount of liquidity that the exchange is able to attract. That is a very significant factor, which is related to the structure of the exchange. Do they provide a robust electronic trading platform? Do they have a market-making system that also assures liquidity and tight spreads? What particular specialist firms work on the different exchanges? Some specialists are particularly good at working on ETFs, and they may not be working on every exchange.

JoI: How will the NYSE/Amex merger impact the industry?

Sauter: I think the merger itself will be positive. We're excited about it. We think it combines the Amex's commitment to ETFs with the NYSE's platform and capital. The other advantage is that it brings together volume that has been fragmented across exchanges. I think we'll see liquidity increase.

I think the NASDAQ is really ramping up their commitment to ETFs, and there will be healthy competition across the combined NYSE/Amex and the new NASDAQ effort.

JoI: What will the ETF market look like five years from now?

Sauter: I think there will be consolidation. I think the marginal products that are narrowly focused and that don't provide good long-term investment opportunities will consolidate, be removed or close down. We've seen a little of that so far. I think we'll see ETFs continue to grow in terms of assets. But I also think most of the assets and trading volume will be concentrated in the 50 largest ETFs, which not coincidentally, will be the most broadly based ETFs and represent the best investment opportunities for a long-term investor.

John Jacobs, executive vice president, NASDAQ

JoI: Do specialists have a role in the future of ETFs?

John Jacobs, NASDAQ (Jacobs): No. Since the NYSE moved ETFs to Arca and the NYSE is buying the Amex, all ETFs will be on electronic markets like the ones NASDAQ OMX has been providing for the past 37 years.

JOI: Has the shrinking size of seed capital had an impact on newly listed ETFs?

Jacobs: Yes. We are seeing some ETFs delayed in coming to the public markets because attracting seed capital has become more challenging recently. However, for some of the larger ETF providers that have a strong track record of developing liquid ETFs, seed capital is not an issue.

JoI: Should investors worry about spreads for active ETFs when they launch?

Jacobs: Investors should always take account of spreads, as they will affect the cost of their transactions.

JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Jacobs: ETF listings are a service to exchange customers— bragging rights, in a sense—and produce very little revenue in and of themselves. The trading activity is where the real competition is and trading activity tends to stick to the primary listing venue during the initial incubation period of new ETFs. As ETFs grow and become more liquid, trading volume is less tied to the listing market and gravitates more to the fastest and most efficient trading venue. The NASDAQ stock market is the most liquid market for ETFs in the United States, and executes over 50 percent of all ETF trading volumes, regardless of where the ETFs are listed.

JoI: What will the ETF market look like five years from now?

Jacobs: Very different. Assets under management will have grown significantly (to multiple trillions of dollars). The large mutual fund companies will probably have emerged as ETF providers, and investors all over the globe will know what the acronym ETF actually stands for. You may even see stand-alone ETF exchanges.

Jim Ross, senior managing director, State Street Global Advisors

JoI: Do specialists have a role in the future of ETFs?

Jim Ross, SSgA (Ross): Probably not … although I say that carefully, because market makers have a significant role to play in the future of ETFs. A lead market maker is almost equivalent to a specialist these days.

Really, I think the role of the specialist has been redefined in the electronic exchange world. Some of their responsibilities have been lessened, and some of the benefits you got as a specialist in the past from an order flow perspective have changed.

I think a lead market maker role will be critical going forward, especially for the newer ETFs. SPY doesn't need a specialist, or even a lead market maker, since the real market for that ETF is so liquid. But for a newer ETF, you need some type of commitment from someone to ensure that a tight market is being made.

JOI: Has the shrinking size of seed capital had an impact on newly listed ETFs?

Ross: From a State Street perspective, we haven't seen an impact for our ETFs. We've been able to get a fair amount of seed capital for our funds. I'm not sure how it works for other funds. I think a lack of seed capital probably stops some ETFs from coming to market, or at least slows them down significantly. [Getting seed capital] is not as easy as a phone call anymore … you can't just call someone up and get $50 million or $100 million anymore.

JoI: Why is seed capital important?

Ross: It helps establish a fund and shows that there are shares out there that are trading. It shows that there is a decent liquidity pool for the fund.
If you look at the parallel with mutual funds, there are not a lot of investors buying new funds with a couple of million dollars in them.
The whole answer, though, isn't getting the seed capital up and going. It's getting the fund running and some real interest and real demand there.

JoI: Should investors worry about spreads for active ETFs when they launch?

Ross: Yes. Active ETFs have the potential of having wider spreads. Spreads are always important, but they have the potential of becoming more important with active ETFs. A fully transparent portfolio will come pretty close to letting you know how big the spreads are, but if we start to see portfolios that are not fully transparent, I'm not exactly sure how that will work.

JoI: What impact will the NYSE/Amex merger have on ETF product issuers?

Ross: I'll take a philosophical approach. I think the ETF listing market was changing whether or not this merger happened. I'm not sure the merger will have a major impact. I think ETF product issuers have seen changes in how listings work and how the specialist system works for years. I think the bigger change happened last year when the NYSE moved everything to its Arca platform. They decided to move away from the specialist system as it existed then. The merger means one less listing venue, but I anticipate that other very viable listing venues will emerge.

Lisa Dallmer, senior vice president, ETF & Index Services, NYSE

JoI: Do specialists have a role in the future of ETFs?

Lisa Dallmer, NYSE (Dallmer): Yes, absolutely. Specialists perform a very necessary function for ETFs. In the NYSE Arca marketplace, we actually call them ''lead market makers.'' The function, however, is the same: to be a liquidity provider and facilitate price discovery for the products they trade. The lead market makers have obligations to maintain a continuous quote, manage the opening and closing auction, provide price discovery and drive the inside quote a certain percentage of time throughout the day. There is still an ongoing role for these professional traders who know how to price the basket of securities and therefore know how to provide price discovery in the marketplace.

JoI: Has the shrinking size of seed capital had an impact on newly listed ETFs?

Dallmer: I would actually suggest that the question be rephrased: ''Has the wave of newly listed ETFs had an effect on seed capital?'' As we've seen more and more products come to market, I think we're seeing a supply-and-demand issue where the product sponsors have a lot of great ideas … some of which are third-to-market, fourth-to-market or even fifth-to-market … and that's having an effect on the marketplace with respect to the supply of that initial seed capital. There's an investor appetite that changes when you get a fifth-to-market product. So for those parties providing the initial seed capital, understanding how a sponsor intends to differentiate and distribute the product in a crowded distribution channel is important. Overall, I believe sponsors are more thoughtfully designing their product sets with more emphasis on innovation and investor demand.

JoI: Should investors worry about spreads for active ETFs when they launch?

Dallmer: I think investors should understand the products they're investing in, whether they're passively managed index ETFs, mutual funds or the new construct of what we're calling actively managed ETFs, which are essentially the actively managed ETFs that are coming out shortly with fully transparent portfolios.
In traditional open-ended mutual funds, of course, there is no bid/ask spread when an investor gets in and out of the fund. However, there are still costs of managing the fund that come in the form of expense ratios, fees you might pay in the form of front-end loads, etc. Those fees represent themselves differently in an ETF. Instead of a commission to your financial advisor, you might see that there is a fee to pay to purchase the security through your broker—a standard transaction fee.
To the extent that there are spreads around the bid/ask of the ETF, it is going to be reflective of what the portfolio is holding, the fund's disclosure of that portfolio—which will be publicly available—and the management process implemented by the fund advisor. The spread of any ETF is based on its underlying holdings.

JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Dallmer: ETFs are part of the broader listing strategy of exchanges. Exchanges compete vigorously for public company listings; we compete vigorously for closed-end fund listings; we compete vigorously for ETF listings. It's in part because there's an order flow benefit that, I would say, oftentimes benefits the primary exchange in the sense that opening and closing auctions are done on the primary exchange. Also, the largest price discovery and liquidity providers are working on the primary exchange. As we're able to win listings, articulate our position and offer valuable services to our ETF issuers, we gain a more dominant position in the growing marketplace.

As a quick example, I'm looking at a statistic we have from the month of February. There was an issuer that had some primary listings with NYSE Arca and some primary listings on another exchange. For the listings that were primarily listed on NYSE Arca, our liquidity providers drove the inside price 91 percent of the time. If our liquidity providers are driving the inside price in our primary listings, we are more likely to be at the best price with respect to other exchanges interacting with our quotes in the national market system, so we are more likely to attract market share. Our market model, which features designated liquidity providers for every primary listing, is a core component of our value proposition to investors and issuers.

JoI: What will the ETF market look like five years from now?

Dallmer: That's a hard question. I think it's certainly going to grow in its offerings to investors. Volume growth is another important element of that question. We handled 285 million shares a day in 2007. That's a 65 percent increase from 2006. We've seen significant growth in the types of assets we are placing in the ETF wrapper. We've seen growth in the product approval process in that we no longer need to have an index per se, and instead we can have a portfolio with an investment objective and a set of securities that is constantly disclosed.

I think we are going to continue to see incremental changes in the marketplace over the course of the next five years, and I think we're going to see assets grow. As a packaging mechanism, the ETF wrapper is very efficient at delivering investors some value-added services like tax efficiency, ease of access and an open architecture.
That packaging mechanism, right now, works very well on transparent portfolios, as we're about to experience with the actively managed products. There are changes that will have to occur in that packaging mechanism if some of them wanted to run a portfolio and not disclose the holdings.

[Regardless of what happens with nontransparent active funds,] I think we're going to see more assets under management, and see the ETF industry continue to grow worldwide. I think we're going to see more refinement of the distribution model. I think 2007 has been a valuable year for issuers to gain experience on the distribution models and understand what really works for them and how their products map fits into financial advisors' needs. I think we're going to see refinement of the existing maturity level of the investor and we're going to see incremental opportunity in the product set over the course of the next three years or so.
Overall, I think ETFs will continue to grow and be a competitive alternative to mutual funds or structured products. The business is growing substantially and NYSE Euronext has leadership positions in the U.S. and Europe.