Increasingly, exchange-traded funds have individuals acting like institutional investors - or, at least, are offering them the tools to do so.
The latest example is a spate of currency funds unveiled by Rockville, Md.-based Rydex last week, which will track six of the most liquid currencies from around the world, those of Australia, Canada, Great Britain, Mexico, Sweden and Switzerland.
These new products join Rydex's CurrencyShares lineup, which debuted with the Rydex Euro ETF on the New York Stock Exchange last December. To date, that fund has attracted $650 million, increased 5.4% and trades about 300,000 shares per day.
"We are giving [retail investors] something they didn't have in the past," said Steve Sachs, director of trading at Rydex. "Access."
Foreign currency can be a good hedge against volatility and a substitute for cash, if used properly as part of one's portfolio, said John M. Mulvey, a professor of financial engineering at Princeton University, who has worked as a consultant to Rydex for nearly a year and a half and who helped develop these funds.
Not only do these currencies offer a new asset class, but it is one with low correlation to other segments of the market and relatively immune to "contagions," or those rare, but large, events that sweep the market, simultaneously weakening stocks, bonds and commodities and turning once-robust portfolios sickly, Mulvey said, speaking during a news briefing at the NYSE last week.
Institutional investors can access such leveraging techniques by going to the spot market, to dealers or to foreign exchanges. But for individuals, these tactics, for the most part, are simply out of reach.
These ETFs change that. The Rydex Currency Funds act as trusts, each with only one asset. In the case of the Euro fund, that asset would be Euros, for example, and in the case of the Swedish fund, it would be kronas. Investors purchase shares with U.S. dollars and can buy as little as a single share. The funds trade on the NYSE, beginning this week, which adds transparency and price assurances not available on the spot market.
The assets for each will be held in an account at JPMorgan in London and accrue interest at institutional rates, which will be paid out as monthly dividends in U.S. dollars, Sachs said. Because they are denominated in U.S. dollars, and traded on the NYSE, the funds are both accessible and bear no special foreign tax liability.
Expenses are capped at 40 basis points, plus bank fees, which, for the Euro CurrencyShares product, has been 27 basis points.
"Its back to, do you have access? Do you like the transparency?" Sachs said.
During a press conference, Sachs dodged multiple questions about potential currency shares to follow, such as one based on the Japanese yen, but did concede that the model could be applied to other denominations.
"We don't see any slowdown of products coming to market," Sachs said. "The trend is capturing innovations and opening new asset classes to investors."
The proliferation of ETFs in the past two years has been remarkable. At the end of 2004, there were 151 funds on the market, representing $226.2 billion in assets, according to a report from the Securities Industry Association. One year later, there were 201 funds with $296 billion.
The surge continues. Between January and April this year, 16 new products came to market, bringing an additional $10 billion in assets, according to SIA data. Earlier this month, PowerShares Capital Management, based in Wheaton, Ill., announced plans to launch 31 new funds, rounding out its existing lineup of 37 ETFs. These funds combine indexing with a quantitative overlay that sets weightings for stocks by tracking 25 various financial, momentum and valuation characteristics.
And Thursday, State Street Global Advisors of Boston introduced six industry-specific exchange-traded funds, bringing its total SPDR roster to 65. The new funds will track metals and mining, pharmaceuticals, oil and gas equipment, oil and gas exploration and production, consumer retail sales, and regional banking.
The SEC has another 23 applications pending, according to spokesman John Heine, and some applications represent several separate funds.
"Exchange-traded funds will become the mutual funds of the 21st century as assets in exchange-traded funds surpass $1 trillion by the end of the decade," heralds a report released in late April by Tiburon Strategic Advisors, a research company in San Francisco.
Other estimates are even higher. In a recent report, New York-based research and consulting firm Celent pegged the ETF market at $1.95 trillion by 2010.
"In terms of aggregate sales, ETFs have done great," said Owen Concannon, an analyst with Boston-based Financial Research Corp. "Certainly, they are finding their way to retail investors as more and more advisors adopt a fee-based business." Rydex is one example of a fund provider that targets advisers, rather than the direct market.
Despite the exponential growth of mutual funds, it may still be premature to suggest they truly rival the $9 trillion world of mutual funds, where investors can choose from some 8,000 products. But the mutual fund market is also more mature, with less demand for new products, while ETFs have room to grow, Concannon said.
"Specialization is gong to continue to be a part of the [ETF] industry's evolution," he said. "They're going to throw a bunch of stuff against the wall, and not everything is going to stick."
But there is a danger of having funds that are too esoteric for many investors. "As you get more and more specialized, the risk of failure increases," Concannon said.
Still, for the company that meets investor demand first, the rewards can be great. For example, Barclays Global Investors and State Street, the first to market with several ETFs, together control more than half of the assets in exchange-traded funds. As of the end of March, Barclays continued to capture 75% of inflows, according to the Tiburon report.
"The segment is growing fast enough that there is a lot of interest on the part of investment firms," said Dan Culloton, senior fund analyst for Morningstar in Chicago.
Whereas the first ETFs started by tracking popular indexes, in some cases, fund providers are actually requesting that indexing firms create specialized indexes in order to accommodate their products. And just as indexes provide opportunities for providers, ETF providers are creating opportunities for indexing companies.
"The classic case is the index sectors. Nobody really paid that much attention to sector indexes until ETFs," said Kelly Haughton, strategic director for Russell in Tacoma, Wash.
The indexer launched a top 50 companies index to support the Rydex Russell Top 50 ETF, tracking the 50 largest companies, and its opposite: a microcap index, which Barclays uses for an iShares fund, Haughton said. Recently, the company finalized a licensing deal with State Street to correlate with a Japan-focused prime index fund, he said.
And, earlier this month, Russell announced it will launch global equity indexes by the fourth quarter of this year, which could lead to some additional ETF launches.
"Index providers and investors are coming up with creative ways of utilizing this product in their investment product," Haughton said.
While there are great advantages for investors and growth opportunities for ETF providers, Culloton warned that flooding the market may erode the value that has made ETFs so popular.
"The trend has been to be more specialized, more esoteric. As they do that, they get more expensive," he said. Likewise, more complicated structures may be less tax efficient, and especially narrowly defined classes run the risk of being only return-chasers.
"I would caution anyone against leaping on the latest new ETF simply because it is now available," Culloton said. "There's nothing wrong with sitting back, taking a deep breath and doing some fundamental analysis."
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