Sales of exchange-traded funds in the U.S. are expected to beat active mutual funds in 2008. If such forecasts prove to be the case, it will mark the first time when net revenue growth by ETFs have topped that of traditional funds, say analysts at Financial Research Corp. 

But the retail juggernaut that ETFs have become in the U.S. obscures the original story of ETF adoption. When the first ETF hit the U.S. market 15 years ago, the SPDRs Trust (NYSE: SPY) was almost exclusively traded by institutions.

A similar ETF market creation story is playing out again, this time in Latin America. Institutional investors in the region, primarily pension funds, are for the first time turning to ETFs in a major way. And that trend, say industry players, is bringing Latin American markets into greater focus with U.S. fund companies.

Copying Success In The U.S.

Big ETF providers are using much of the same blueprint for success that they used in the states when expanding south of the border.

For example, the first product that State Street Global Advisors introduced in Chile for pension funds was SPY. At the end of August, the ETF had attracted some $370 million in assets over the past four years through the Chilean pension market alone. And that's considered a baby step.

Saga is getting ready for a full-scale SPDRs rollout in the country; that is the biggest pension market in Latin America that is truly open to foreign investment. Chilean regulators increased to 45% this year the amount that pension funds are allowed to invest in foreign funds. While Brazil has a larger total asset level in its pension pool, the market is tightly regulated by the Brazilian government.

But Saga is far from alone in picking up the pace with ETFs in Latin America. Barclays Global Investors catapulted from 24^th among foreign investments used by pension managers in Chile just two years ago to No. 1 in the market this year.

Daniel Gamba, who heads BGI's operations in Latin America, says that the region has been the fastest-growing market for the company worldwide over the past three years.

By The Numbers

A look at projections for the Latin American market shows why ETF companies are moving quickly to attack the asset-gathering opportunity.

Latin American mutual fund and pension fund industries are growing at a 20% clip per year, according to the most recent Latin Asset Management/Cerulli Associates report on the market. Furthermore, Cerulli predicts that by 2012, cross-border allocations by Latin American pension funds will reach $246 billion, $132 billion from Chile alone—which is more than the current total size of the Chilean pension market. Compared with mutual funds, two-thirds of future cross-border flows in Latin America will be from the pension market.

The forecasts are based on the quiet growth story that has already occurred. In 2003, between Latin American pension funds and mutual funds, there was a total of $305 billion in assets. That figure is expected to jump to $2.5 trillion by 2012, with foreign pension and mutual fund assets representing 14% of the total. For the pension fund market specifically, where ETFs are making their greatest early inroads, the market grew from $167 billion in 2003 to $448 billion at the end of 2007, a 168% increase. In Chile, Peru, Argentina, Colombia and Mexico, pension sponsors are taking in more than $1 billion per month, according to Cerulli data.

In terms of specific pension markets, growth at least doubled in the five-year period between 2003 and 2007, and in some cases, grew at a much higher rate.

What's more, the foreign investments' gain is the domestic funds' loss. Domestic allocations of pension funds went down in every major Latin American country between 2003 and 2008. And there is a looming fund gap that represents a big opportunity for ETF sponsors as well. Based on the relaxation of the foreign investment limit in Chile, and the increase in foreign investment being made by other Latin American pension markets, Cerulli expects a $21 billion gap between what is actually invested in foreign funds and the maximum limit that will be allowed at the beginning of 2009.

Cross-border investment by pension plans in Chile, Colombia, Peru, Argentina and Mexico was $49 billion in 2006, $72 billion in 2007 and projected to be $101 billion by year-end 2008.

Of course, it must be noted that these growth rates are so eye-popping because the markets are relatively small compared with other global pension markets. And not all the news is positive. While Chile has increased the foreign investment percentage for its pension market this year, Argentina has recently re-nationalized all of its pension plans. That makes the situation much trickier for asset managers, who over the past five years had the relative luxury of dealing with private financial services firms running pension assets for the Argentinean government. And it is the kind of problem that will always be a potential risk for asset managers staking claim to growth in less-developed pension markets.

Current ETF Efforts

BGI has 148 iShares in Chile, where U.S. ETFs do not have to be cross-listed specifically, but registered with the local financial authority. Currently, BGI is focused on introducing a wider range of fixed-income iShares for Chile's "hugely growing pension market," as described by Gamba. BGI has $13 billion in ETFs across Latin America, with Mexico representing between $6 billion to $7 billion and Chile with approximately $5 billion in assets.

BGI has 30 people focused on Latin America, and seven each in its Mexico City and Sao Paolo offices. Gamba says those two Latin American offices will double or triple in staff over the next two years.

WisdomTree Investments has also begun an institutional marketing effort in Latin America for its ETFs. And fund giant Vanguard Group is also active in Latin America, specifically in Chile and Mexico.

(Since Vanguard's ETFs are a share class of its existing traditional mutual funds, its institutional marketing focus on Latin America is still tied primarily to the traditional funds.)

Upstarts are on the rise south of the equator, as well. Global X Management, a New York City-based, soon-to-launch ETF sponsor, will be targeting investors across Latin America. It plans to launch country-specific products for Argentina, Peru and Colombia.

And index providers continue to expand their Latin American benchmarks. Global X, for example, has teamed with Dow Jones and FTSE to create custom country indexes for its country-specific Latin American ETFs. Also, iShares recently filed for a country-specific Peru portfolio, based on a brand new MSCI All-Peru Index.

The Retail Reality

Retail mutual fund markets are also growing across Latin America. But it's apparent why ETF companies are going after pension assets first and foremost.

While some $132 billion is projected in foreign investments for Chilean pension assets by 2012, within that same period, just $107 billion is expected to come into foreign-run mutual funds throughout Latin America. What's more, in that time frame, the projected cross-border mutual fund investment from Chile, Colombia, Peru and Argentina combined is only expected to be $61 billion.

The retail equation is much trickier than the pension effort, too. In Chile, for instance, foreign managers are not allowed to promote funds directly to a retail audience.

"Mexico will be the retail driver at first, and in a market like Chile, it is more about setting up the local exchange and platform relationships, having the aspirations, and being ready to go," Gamba said.