Global ETFlash – February 12, 2013


Thoughts From The World’s Largest ETF Forum

By Tyler Mordy, Director of Research & Co-CIO

Hollywood, Florida has become the ETF industry equivalent of Davos, Switzerland. Each year, IndexUniverse hosts the “go to” conference here for leading advisors, portfolio managers and ETF aficionados of all stripes.

We have been a regular speaker at this event since its inception, and each year the drumbeat grows louder. This is the 6th annual event with a record 1,300 in attendance.

It wasn’t always this way. In fact, ETFs are rooted in humble beginnings (the first one was actually launched — to little fanfare — in Canada in 1989). It was a long slog from there, to the booming industry it is today. Yet, the ETF industry is still a nascent one. We are only in the foothills of a long journey.

Where to next? Below, seven observations from the Davos of ETFs.

1. ETFs are hotter than the Kardashians. After 25% growth in 2012 and a stellar January, worldwide exchange-traded products hit 2 trillion. Is anyone predicting slower growth ahead? Not a chance. This is not a fad investment (as many naysayers have repeatedly predicted).Yet, it is still a game of winners and losers. One conference panelist predicted more ETF closures than launches in 2013. That may be the case, but the real driver of ETF asset growth is low-cost, transparency and the sheer breadth of asset class content available (ETFs have colonized virtually every global investment class). Taking that view, expect a new AUM record next year.

2. The financial sector is still shrinking. Judging by the enthusiasm of this event, one would be forgiven for thinking it was 1999 in the financial sector. We assure you it is not. Since the early 1980s, the financial sector benefited from an unprecedented credit expansion. By 2007, US financial earnings accounted for more than 40% of corporate profits. Since 2008, however, there has been a widespread recognition that the sector had grown too large. Many had forgotten that the financial sector’s basic function is to supply capital and transactional systems to support growth in the real economy (not the other way around).

The ETF trend is driven by a shift to more reasonable fees and, most importantly, making active decisions where it counts most. In many respects, ETF investing is a return to the basics – casting aside much of the legacy portfolio architecture erected in the 1980s and 1990s (i.e. the siloed approach to investing) and pursuing unconstrained global multi-asset class investing. Perhaps ironically, ETFs are part of the solution to a smaller financial sector. (Viewed in that light, we really are doing “God’s work” (sorry Lloyd!)).

3. The fee war is on. At the top end, it’s a race to the bottom in fees. The world of clashing (and slashing!) ETF titans – Vanguard, Blackrock, State Street and now Charles Schwab – heated up in 2012, with all of the major players announcing price cuts. We have always favoured “pure beta”, so why pay more for the same basic exposure? Schwab now offers ETFs with a price tag as low as 4 basis points. Battle on!

4. It’s still a macro world. Despite persistent predictions of a return to a “stock picker’s market” (our least favourite Wall Street spin), it has not happened. Macro still matters. In fact, macro is here to stay. Consider the tectonic shifts taking place in the global economy –- greater economic synchronization (we now have a global business cycle), heightened capital mobility and increased government involvement in financial markets. These are longer-running trends that will not reverse anytime soon.

In our view, ETFs and macro investment approaches have always been a perfect matrimony. In a globalized and slow-growth world, creating “alpha” from global tactical asset allocation ETF portfolios is likely to be a much easier route than traditional approaches.

5. Commodities are no longer a one-way bet. My panel discussion this year focused on commodity ETF investing and the outlook. The consensus is that ETFs supply the most efficient exposure to that asset class. However, the outlook was more clouded for commodity prices in general.

Of course, the million dollar question relates to the so-called “commodity supercycle”. Is it over? In our view, the easy money has already been made. In the last 200 years, the US has witnessed 6 secular commodity bull markets, with an average length of 16 years and total return of 202%. We are very close to those numbers (using 1999 as the starting point).

Even so, the risk is that the pendulum swings too far the other way. The average commodity hedge fund was down 1.4% in 2011 and 3.7% in 2012 (while broad commodity indices were roughly flat). Pension funds and other institutional investors are in retreat. Calpers, America’s largest pension fund, withdrew 55% of its holdings in commodities indexes late last year (leaving just 0.6% of the fund invested in commodities). That seems extreme but also spells opportunity. Going forward, ETF investors should have fertile opportunities for tactical moves in the major commodity classes. Having a repeatable process here will be critical.

6. The Canuck contingent is well represented. Of course, the poolside venue has nothing to do with a growing Canadian attendance. (See my CNBC appearance last year, live from the shores of Florida). However, it highlights that growth in the ETF industry is not just a US phenomenon. Indeed, the tentacles of the ETF movement are reaching far beyond American borders.

7. ETF Managed Portfolios are the next growth area. The list of ETF converts is growing by the day. Ultimately, however, ETFs are simply tools. The missing ingredient has always been the investment process. Therefore, the natural next wave (as index guru Matt Hougan predicted in his opening remarks) is in the ETF Managed Portfolio space. These are strategists who build portfolios exclusively using ETFs, typically focusing on the active asset mix decision as a means of alpha generation. Morningstar now has a dedicated team tracking these managers (http://www.morningstar.com/advisor/etf-managed-portfolios.htm).

Looking Ahead
The theme for Davos’ world economic forum this year was “resilient dynamism” (whatever that means). For the ETF industry, “relentless development” may be more appropriate. Or, to borrow Dennis Gartman’s words from the global macro panel, “preposterously bullish”. Whatever the phrase, the outlook is bright for the ETF investor.

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