Wealth Manager

Impressive, but the game has only just begun. ETFs are said to
be competition for mutual funds, and by that standard the ETF
boom has legs. At the end of 2005, ETF assets in the U.S. totaled a
mere 3 percent of the $8.9 trillion in mutual funds, the ICI reports.
If ETFs are destined to grab money from mutual funds, the golden
days of growth are still ahead.

There’s just one small glitch. Each and every new ETF needs an
index—these are index funds, after all. But after 14 years of minting
product, there aren’t a lot of widely recognized indices left that
haven’t already been securitized in an ETF. Yet if last year’s pace
holds steady for the next 10 years, more than 1,500 new ETFs will
arrive between now and 2017. Keeping the IPO shoot greased, then,
means that ETF providers must find 1,500 indices above and beyond
the existing pool of names already in use.

How will the market cope? There are five basic solutions:
1. Invent new benchmarks.
2. Dig deeper into the remaining supply and tap the relatively
obscure indices not already tethered to an ETF.
3. Tweak the old benchmarks, by offering levered or short exposure
on familiar indices, for example.
4. Focus on asset classes with thin or nonexistent representation
in ETFs.
5. Convince the SEC to approve actively managed ETFs.

The first four solutions are already popular. Meanwhile, the actively
managed ETF remains a regulatory question mark for the moment,
although the idea is reportedly close to receiving SEC approval.
In fact, all five solutions are likely to prevail over the long
haul. The bottom line: ETFs in the future will look radically
different from their predecessors. The days of rolling out new
funds that track familiar indices with obvious appeal are drawing
to a close. Increasingly, the ETF marketplace will be defined
by innovation in indexing.

It’s too soon to say if the trend represents progress—or something
less—but this much is clear: The next wave of ETFs will introduce
a new palette of opportunities and risks, much of it untested
beyond paper trading. That’s quite a contrast to the ETFs of the
first decade or so which were characterized by well-known indices
with widely understood risk/return profiles from the likes of S&P,
Russell, MSCI and Dow Jones.

The learning curve has been relatively undemanding for ETFs
until recently. The future promises to be more complicated. In fact,
the future is already here. “If you look at last year, there were a lot
of new ETF product introductions, and many of them have been
based on new indices,” observes Scott Ebner, senior vice president
of the American Stock Exchange’s ETF division.

That includes PowerShares’ latest installment of so-called
fundamentally weighted sector ETFs, which compliment earlier
rollouts of broader minded equity ETFs cut from the same indexing-
design philosophy. The underlying benchmarks are the
brainchildren of Research Affiliates, which was founded in 2002 by
Robert Arnott, a respected veteran of the investment management
business. His current firm has been at the forefront of rethinking
and reinventing market-cap-weighted equity benchmarks with an
eye on enhancing returns and minimizing risks. Before teaming
up with Arnott, PowerShares launched a suite of quasi-actively
managed ETFs, rolling out its first product back in 2003. Its first
fundamentally weighted ETF tracking a Research Affiliates’ index
arrived in December 2005.

Critics say that some of the firm’s ETFs are not really index funds,
even though they track benchmarks. The basis for the charge is that
the underlying indices favor certain stocks as per a rules-based system
for selecting companies designed to deliver superior results
relative to a cap-weighted index. Arnott counters that there are better
ways to index than the standard market-cap weighting system.
PowerShares’ brand of ETFs may be controversial, but minting
new ETFs that stray from conventional notions of indexing is a
growth industry. Consider the Claymore/Ocean Tomo Patent, an
ETF launched last fall that replicates an index focused on stocks
deemed to own “valuable” patents. The same firm also recently
launched The Claymore/Clear Spin-Off ETF, which hugs a benchmark
comprised of companies that have been recently spun off,
or separated, from corporate parents. And in early March, XShares
Advisors launched nine narrowly focused healthcare ETFs, including
the HealthShares Metabolic-Endocrine Disorders fund.

The point is that indices aren’t always passive gauges. Benchmarks
can be engineered to perform any number of quantitative feats, which
may or may not reflect the unmanaged returns of an asset class. Many
of the quantitative screening processes that are embraced by active
managers can be repackaged as rules-based benchmarks, which in
turn can be used as the basis for index funds. That’s a plus for ETF
providers searching for new ideas to fuel product growth.
Imagination, entrepreneurial spirit and vigorous marketing,
in other words, are in high demand for keeping the ETF business
humming. For instance, last year WisdomTree Investments began
selling several funds tracking indices that weight stocks by earnings,
or if you prefer, by dividends.

Love it or hate it, such ideas are gaining traction. WisdomTree
has been creating ETFs for less than a year as of this past January,
and already it had about $2 billion under management, according
to Morningstar Principia. PowerShares, which started in 2003, had
more than $9 billion in ETF assets by that time.

A byproduct of the rising tide of ETF launches is a lively market
for thinking up new benchmarks. A sign of the times is the appearance
of IndexIQ, a one-year-old Rye Brook, New York boutique
firm that designs indices that “bridge the gap” between active and
passive money management. So says Adam Patti, CEO of IndexIQ,
which licenses its benchmarks to ETFs, separately managed accounts
(SMAs), institutional funds, and anyone else looking for
different spins on indexing.

One example of the IndexIQ mindset: Building indices that
weight equities according to their innovation. How do you measure
innovation? There are a variety of metrics, Patti says, including
capital expenditures, the amount of spending on research and
design, and new product developments. “Our Innovative Companies
Index seeks to identify companies that, through strong reinvestment
and commercializing their innovation, are consistently improving their financial results,” he explains. Other indices focus on companies with relatively strong profits or companies said to harbor enduring competitive advantages.

As we go to press, 20 ETFs linked to IndexIQ indices are in registration,
Patti reports. The ETFs will be managed by XShares Advisors
in New York. But that just scratches the surface of IndexIQ’s
inventory—and ambitions. Patti tells Wealth Manager that the company
has 20 families of metrics (innovation being only one), which
represent about 200 indices.

The peculiarities of ETF regulations are driving the surge in
index design. ETF managers are currently required to track indices
that are crafted and maintained by separate entities. But no matter
who invents the indices, in theory the sky’s the limit. IndexIQ
signaled as much with its recent launch of a family of “synthetic”
hedge fund indices to round out its offerings.

As any quantitative analyst knows, there’s no shortage of investment
factors to slice and dice, and so the available supply of new
indices is theoretically unlimited. Market capitalization may still
be the dominant factor in terms of indexed assets under management,
but ETF providers are challenging the status quo.

In short, prepare yourself for a wave of new ETFs tracking indices
whose benefits, if any, aren’t immediately obvious for long-term investment
strategies. But for short-term, speculative-minded traders,
the opportunities are endless. Perhaps there’ll be an ETF tracking an
index of companies posting the biggest earnings surprises. Or the
biggest change in price volatility. Why not combine both factors?

The new world order of ETFs may reward creativity, but it threatens
to tax investors as they attempt to separate the worthy from
the foolish. In contrast, most informed investors understand what
they’re getting in funds replicating the S&P 500 or the Lehman
Brothers 7-10 Year Treasury Index. As the ETF business moves into
uncharted waters, the burden of due diligence will grow for those
intent on sampling unexplored terrain.

Invariably, the marketing brochures for the new indices and their ETF
offshoots cite the fabulous results of back-testing. Only those strategies
that hit the back-test pay dirt are given the opportunity to graduate to
ETFs. That would seem to weed out the great ideas from the bad ones.
But investing isn’t quite so simple. As any seasoned investor knows,
a paper history doesn’t insure success after a transplant into the real
world where taxes, trading costs and other challenges apply.

Regardless, a much larger pool of ETFs is coming to your investment
menu soon. There are thousands of mutual funds, notes
Arnott, and there’s no reason there can’t be thousands of ETFs.
A fair amount of the increased demand for ETFs is coming from
the investment profession, says Tim Meyer, ETF business manager
at Rydex Investments, a firm that is no stranger to offering distinctive
funds in both open-end and ETF formats.

But not every wealth manager sees the burst of ETF ingenuity as
a positive. “As a lover of ETFs, I find it somewhat discomforting that
we’re seeing all these pet indices and some silly notions come into the
ETF market,” complains Russell Wild, a principal of Global Portfolios
in Allentown, Pa. and author of Exchange-Traded Funds for Dummies.
Bill Bernstein of Efficient Frontier Advisors in Eastford, Conn. is also
skeptical of the new crop of ETFs. “The first ETFs that came out were
good products,” says the author of The Four Pillars of Investing: Lessons for
Building a Winning Portfolio. “The Spider is a great product; Vanguard’s
Vipers are great products, and Barclay’s iShares are, too. But it’s gradually
gone down hill. The fees are increasing, the spreads are increasing,
the marketing’s increasing and so is the starting up of hot funds.”

PowerShares, WisdomTree and other new-generation ETF companies
beg to differ. Each fund business believes it’s adding value. The fact
that money’s pouring into the new products suggests there are more
than a few investors who agree. Yet the surge of new funds threatens
to overwhelm. “The biggest risk is that there are so many ETFs that it
gets confusing,” says Barry Ritholtz, chief market strategist at Ritholtz
Capital Partners, which uses ETFs in clients’ portfolios.

Ultimately, a secular bear market on Wall Street may temper the
zest for new funds. There will be a limit to how many new ETFs the
market will tolerate, even in the best of times. But it’s not yet obvious
where that limit lies.

“At the end of the day, the market’s going to determine when too
much is too much,” says the Amex’s Ebner. “But I don’t think we’re
anywhere near that for ETFs.”