When State Street Global Advisors launched the first exchange-traded fund in January 1993, it was marketed primarily to institutions as a way for them to execute sophisticated trading strategies such as hedging. Finally, there was a low-cost, tax-efficient investment vehicle they could trade like a stock. Over the next few years, Barclays launched its World Equity Benchmark Series (later to be renamed the iShares MSCI Index Fund Shares), and a few other asset management firms began following suit. For many years, there was no denying it: The funds were off to a slow start.

But when the market took a turn for the worse in the summer of 2007, and advisors were desperately trying to keep clients from jumping ship, ETFs became the vehicle of choice. Suddenly, investors were taking real interest in the benefits of ETFs: low cost, tax efficiency, transparency and liquidity, to name a few. At a time when the market was swinging by hundreds of points a day, you could buy or sell a position and not wait for the market's close to find out the price. You could short ETFs; you could write options against them to hedge a position. Trading volumes soared to 2.68 billion shares per day at the market's low in March 2009, from 714 million shares per day in October 2007, according to Morningstar. And ETF assets, which had been gaining heft steadily for years, hit an all-time high.

Today, 789 ETFs hold assets of $702.4 billion-a more than 90% rise over the past three years. Although this is meager compared with the $7 trillion mutual fund market, industry analysts now consider ETFs the most significant product development since mutual funds. Niche products are popping up all across the investment spectrum, as providers find creative-and sometimes controversial-new ways of marketing this asset through leveraged products, 401(k) plans and even active management.

The very first ETF, the SPY, still sits at the apex of the ETF universe with $69 billion in assets, accounting for 10% of the industry's aggregate holdings. But little else has remained unchanged in this part of the market filled with rapid innovation, infinite opportunity and passionate debate.

DRIVING THE NEW VEHICLE

During the 18-month recession, ETFs accounted for 30% to 40% of trading volume and were the single biggest driver of flows. Thanks to educational efforts by fund providers and analysts that had been in full force long before the market began to sink, investors had begun to recognize the unique qualities ETFs offered. "The markets were moving so fast, even 700 or 800 points in a single day, that people started to realize they can control the entry point into and out of the market using ETFs," says Tony Rochte, senior managing director at State Street Global Advisors, one of four ETF providers that dominate the market. "In mutual funds, the only thing you know is you can trade when the market closes."

While liquidity drew many to these funds last year, their transparency also played a key role in attracting dollars. Because they are traded on a daily exchange, ETFs must report their performance and holdings each day on the fund's website. This transparency became prized after scandals ranging from Madoff to Stanford and beyond prompted investors to demand to know where-and how-their dollars were being deployed. The result: massive flows into fixed-income ETFs which, despite accounting for only 69 of the nearly 800 ETFs, hold nearly 13% of the industry's assets ($90.9 billion), according to Morningstar.

Financial advisors began reevaluating what their clients had said about their risk tolerance, Rochte says, and bond ETFs became an important part of advisors' tool kits. Many RIAs also turned to fixed-income ETFs, as it became increasingly difficult for them to justify charging clients a 1% fee, while they were earning just .08% in a money market fund, says Sue Thompson, national sales manager of the RIA team for the U.S. iShares business at Barclays Global Investors, another top player in this space.

And so fixed-income ETFs became one of the most commonly traded products of the recession. Short-term Treasuries were the funds of choice for many as the SPDR Barclays Capital 1-Month T-Bill, for instance, traded more than a million shares per day and now holds assets upward of $1 billion, according to Rochte.

Bond ETFs were the top asset-gathering class in the ETF universe through the end of August. Nevertheless, the bond ETF market is still relatively small with plenty of room for growth. But there are some hurdles. Since many bonds, such as municipals, become fully subscribed the day they are issued, providers worry that a lack of new issues could curtail the number of new products that hit the market. "Supply and demand have been a tremendous concern over the past 18 months," admits Michelle Nigro, head of sales for financial advisor services at Vanguard, another large contender in the ETF universe and a provider of 39 fixed-income ETFs.

The Wall Street Journal recently published an article chastising bond ETFs, claiming investors have paid more for them than the portfolios are worth. The piece singled out Vanguard's Total Bond Market ETF, saying the fund's share price has been equal to or above its net asset value (NAV) 98% of the time since its April 2007 launch. In fact, the article said, "On Sept. 30, 39% of U.S. bond ETFs traded at a premium of greater than 0.5% to NAV, according to Morningstar."

SECTORS OVER SINGLES

Some of the investors who flocked to ETFs were seeking much more than a safe haven. Over the past 10 years, ETFs have also been increasingly used as substitutes for single-stock exposure, and the recession only accelerated this trend. Investors grew wary of putting their money into any one name as even the most blue-chip of companies proved untrustworthy during the economic meltdown. "Advisors and professional investors were moving from buying the right individual equity to buying parts of the market or parts of the economic landscape, and ETFs are ideal for that," explains Michael Sapir, co-founder and CEO of ProFunds. "Most studies show that portfolios are more impacted by the sectors the securities are in than the individual securities."

Advisors themselves were slowly using ETFs as a way to diversify clients' portfolios while limiting risk. For years, advisors turned to sector mutual funds to gain this type of exposure, but as the market tanked and advisors looked for somewhere cheap and convenient to invest clients' money, ETFs took a front-row seat. In fact, as more than $160 billion bled from mutual funds last year, ETFs enjoyed positive inflows of more than $156 billion, according to Morningstar.

"People are migrating to baskets of securities to implement broad themes, whether it be oil, healthcare or financial services," says Dan Dolan, director of wealth management strategies at Select Sector SPDRs. "While people used to see sector investing as risky, it's now used as a way to mitigate risk."

HEDGE-O-RAMA

Advisors also used ETFs to hedge client investments against the market's erratic fluctuations. Many invested in gold, for instance, namely SPDR Gold Shares, whose assets nearly doubled from just $18 billion last December to more than $34 billion this September, Rochte said.

But as the market continued to tumble, the urge to leverage against its volatile swings grew deeper, and investors searched for another way to hedge against the uncertainty. Some, mostly professional investors, turned to leveraged ETFs. While shorting was introduced in mutual funds in1993, ProFunds didn't launch the first four leveraged inverse ETFs until June 2006, after regulatory restrictions on shorting made this sophisticated technique difficult to execute within mutual funds.

Today, 117 leveraged ETFs and 115 leveraged inverse ETFs trade on the open market. Although they hold only 5% to 7% of the ETF assets, they remain second in number of issues, according to Tom Graves, a member of the ETF research team at Standard and Poor's. This sector of the industry is ruled by two key players: ProFunds, which now has 78 leveraged ETFs with $22.4 billion in assets as of Oct. 14; and Direxion, which has 21 three-times leveraged ETFs, holding $4.6 billion in assets.

Inverse ETFs are made up of a basket of securities that replicates a specific index and seeks to magnify the performance of that index each day, either positively or negatively. On a 3x long ETF, for example, the baskets of securities will make up about 80% to 90% of the fund. The fund's managers will then use the fund assets as collateral to buy derivatives, such as total return swaps, futures and options, to gain the additional 210% to 220% exposure needed to provide three times the performance of the given index. Rebalancing occurs daily, as the fund must represent three times the net asset value of the index when the market closes each day. For inverse leveraged funds, the provider uses the net assets to buy swaps for the entire 300% each day.

Most advisors use these complex funds on a short-term basis to implement a variety of strategies ranging from mitigating risk to quickly enhancing return. And as the market shows strong signs of recovery, some advisors are even using leveraged ETFs to lure wary clients back into the market. "After a meltdown, people are hesitant to go back into the market," Sapir says. "Leveraged ETFs allow the appropriate client to inch back into the market with less principal at risk, getting a little bang for their buck on a daily basis."

 

TROUBLE IN PARADISE

But leveraged and inverse ETFs have undergone intense scrutiny this year as regulators question their suitability for most investment plans. On June 11, FINRA issued a statement declaring, "inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading day, particularly in volatile markets." The statement also warned financial institutions, saying "recommendations to customers must be suitable and based on a full understanding of the terms and features of the product."

The issue at hand was that the daily compounding that occurs in these funds makes them risky to hold for more than one day during volatile markets. Andy O'Rourke, senior vice president at Direxion Funds, gives the following example:

* Day 1: The index rises. The ETF tracks closely to the goal of three-times the index's daily return.

* Day 2: The index rises. The ETF now has more than three-times the performance of the index because it compounded Day 1 and Day 2's returns.

* Day 3: The index rises again. The return rises further. You have now compounded three days' positive returns on top of one another, so your personal holding is greater than three-times the return based on your initial investment.

* Day 4: The index drops significantly. You see those excess returns wiped out completely. Your personal holdings drop by more than three times the negative performance of the index because, given the compounding of Days 1-3, your holdings represented more than three times your initial investment.

"If you're watching your portfolio every day, you can manage it," O'Rourke explains. "On the third day, you could sell off a bit to bring your exposure back down to three-times your initial investment. But you can't do that if you're only reviewing your portfolio once a month. When you have very volatile markets, you're getting whipsawed all over the place, and the mathematics never catch up."

While compounding can have its upside-earning the fund enhanced exposure to a rising index-the market's recent volatility has shone a harsh light on the negative effects of compounding in these products. After the FINRA statement was released in June, Edward Jones announced that it would ban the sale of leveraged ETFs, calling them "extremely dangerous." In the months that followed, bans spread like wildfire, with Ameriprise, LPL Financial, Raymond James and UBS all either ending or restricting their sale of leveraged ETFs.

FROM THE HORSE'S MOUTH

ETF providers are the first to insist that their products aren't for everyone. ProFunds, for instance, has created continuing education classes, webcasts and studies dedicated to educating investors on what-and what not-to expect from leveraged ETFs. In addition to the warnings splashed across its website, Direxion will soon launch an e-learning module that will let investors assess their knowledge of the funds, learn how they work and determine whether they are suitable.

So just how long should leveraged ETFs be held? Most analysts and providers agree that, if rebalanced often-sometimes even daily-these funds can be safely held for extended periods of time. According to Sapir, who has done extensive research on the topic, the suggested holding period of a fund is dictated by its volatility.

"On diversified indexes like the S&P 500, there's a more than 90% chance that, over a month, a 2x S&P 500 ETF could get close to its daily target. You can get reasonably close to the daily target by rebalancing approximately every three months or every 80 to 90 days," he says. "The less volatility in the index over the short-term, the longer on average you can hold it and get closer to the index and the less frequently you need to rebalance." For riskier funds, such as a 2x China ETF, Sapir recommends more frequent rebalancing.

Invesco PowerShares, the final leader in the ETF space, saw this controversy as an opportunity.

Along with Deutsche Bank, it markets a family of leveraged and inverse ETNs that reset monthly in an effort to quash investors' fears over daily compounding and the impact volatile markets can have on products that reset leverage daily. Still, Ed McRedmond, senior vice president of portfolio strategies at Invesco PowerShares, warns that these funds have their own nuances. Because they reset leverage on the first day of each month, McRedmond explains, investors who buy during the month may see returns that reflect a leverage that differs somewhat from the target since the end of the previous month.

So should the average financial advisor be giving these intricate financial instruments a thought? "Most advisors don't want the high maintenance of having to trade them every day," Dolan says.

But those advisors implementing a (very) active strategy may find these products useful. "They are short-term trading vehicles for people who are actively trading, constantly monitoring their portfolios, making trades and actively managing them," O'Rourke says. "Some RIAs implement those types of tactical strategies for their clients, and they may be candidates. But for RIAs who implement a long-term strategic type of portfolio management where they're monitoring no more than once a month-or even once a quarter-then absolutely not."

While the providers of these funds are first in line to temper the expectations of these funds, they hate to see broker-dealers ban them. If these funds are banned or restricted, they say, qualified investors who are using these funds successfully could lose access to them.

That could explain why others are focused on creating sharper suitability requirements that will put these complex but useful funds in capable hands. "I'd put it in the same context as hedge funds," says Ken Leon, senior director of U.S. equity research at Standard and Poor's. "If you're an investor on a website and want to go into hedge funds, you cannot access them until you go through suitability and compliance. I think you may see the same thing for leveraged ETFs."

ROOM TO GROW

No matter how you look at it-or how you use them-it's easy to see that ETFs have come a long way in their short existence. But these products are still in their infancy, with plenty of room for growth and innovation. One such innovation is actively managed ETFs.

Once the long-standing passive versus active argument was reignited after last year's meltdown, a few firms saw an opportunity. Grail Advisors saw that the passive marketplace was already controlled by four major companies and decided instead to focus on the nascent but active arena. Grail launched its first actively managed ETF on May 4 and now has five fundamentally actively managed ETFs trading on the open market. Now, less than a year since their launch, 31 actively managed ETFs trade on the open market.

But these inventive new products have had trouble getting off the ground. The active ETF space had only $470.3 million in assets as of Oct. 8, representing a minuscule .07% of the industry's aggregate holdings. One possible reason for this lack of flows is that the nature of active management makes it nearly impossible for these funds to deliver the benefits that attract so many investors to ETFs.

For starters, these are not plain-vanilla funds. While most ETFs have individual stocks or bonds in their baskets of securities, active ETFs often deviate from their underlying indexes, using complex instruments such as futures contracts, swaps or derivative contracts, thus making transparency difficult, Leon says. Adding to the problem, active ETF managers who do strive to bring that transparency to shareholders could run into trouble.

"The difficulty with true active management is when you have real investment insight like that, you don't want to tip the market," as someone could front-run your trades, explains Thompson. "To have a liquid, tradable ETF, you must publish the securities you want the authorized participant to deliver to get the ETF shares back. It's like playing poker and showing your hand to the person next to you."

DESPERATELY SEEKING A VALUE PROPOSITION

Another problem for active ETFs is the short time they've been on the market. Add that to the fees inherent in active management, and it's easy to see where these funds could hit a roadblock. "Advisors are saying, 'If I pay this fee, am I getting good value? Is it meeting its benchmark?'" Rochte says. "They want to see performance over a three- to five-year period, but most of the actively managed ETFs out there today just haven't been around long enough."

Due to such problems, fund companies have had a difficult time getting actively managed ETFs through registration. But the unique issues that come along with these innovative new funds aren't only holding them up with the SEC-investors too are wondering why they should buy these funds. "What is the value proposition?" Sapir asks. "Why are they potentially a superior delivery vehicle for active management versus others that are already established? I don't think that has been articulated up to this point."

The future is up in the air for actively managed funds. Grail's first actively managed ETF has only $5 million in assets today, while the largest active ETF, in terms of assets, holds just $167 million. Still, despite meager holdings and a bevy of obstacles, many in the industry are hesitant to downplay the potential impact these funds could have on the ETF universe should they begin to gain assets.

 

WHAT'S THE HOLDUP?

Another area with room for growth in the flourishing ETF realm is the 401(k) market. For decades, mutual funds dominated the 401(k) space. But as ETFs have crept into nearly all parts of the investment market once ruled by mutual funds, many in the industry wonder—what's the holdup? After all, ETFs are known to nearly eliminate tracking error. Implementing ETFs into 401(k) plans, though, poses obstacles the industry must overcome to make significant headway.

Thompson calls such obstacles "a plumbing issue." "Most recordkeepers had systems that were adapted for mutual funds, which trade for the T+1 (trade plus one day) environment," he says. "ETFs trade on an exchange or T+3 environment, so you must mesh those two environments together since most people don't want a pure ETF or a pure mutual fund solution. The other thing is fractional shares, which you can get in mutual funds, but which are not possible in ETFs."

To Vanguard's Nigro, deciding whether ETFs belong in a 401(k) plan is more a matter of size. ETFs don't make sense in plans at the large end because those companies can get a much cheaper plan using mutual funds without the additional fees ETFs trigger. They do, however, make sense for small- and mid-level companies, Nigro says. "Nonetheless, I can guarantee somebody will figure out how to get it done, because this is where the assets are."

Barclays seems to have fixed some of those plumbing issues. The company recently announced an arrangement with SunGuard that will make it easier for SunGuard 401(k) participants to invest in ETFs. The future of the industry could also lie in the college-saving and philanthropic markets as providers recently rolled out the first 529 and donor-advised funds to invest in ETFs.

The ETF industry has made significant strides over the last 16 years, but further consolidation is a given. The five-year product explosion came to a screeching halt last year, as 50 ETFs liquidated and four providers left the space. As of Oct. 7, 112 ETFs had less than $100 million in assets and 54 held less than $50 million, leading many to wonder if the industry can support nearly 800 funds. Now its future will depend on providers' ability to develop new products, recognize growth opportunities, and overcome obstacles. "There will be more assets and fewer products," Dolan says. "The ones that stick around will be bigger than ever. It's back to basics, survival of the fittest."