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October 3, 2011

The Big Impact

How Exchange Traded Funds Are Shaking Up the Industry

By James Armstrong

From zero to $1 trillion in assets. That's how much exchange-traded funds have grown in 18 years-and it may just be the beginning. Experts predict even more explosive growth, with ETFs likely doubling in the next few years and having an enormous impact on the entire trading industry.

Reggie Browne, Knight Equity Markets

Earlier this year, ETFs made up between 25 percent and 30 percent of total market volume. But as trading heated up this summer, they rose to as high as 40 percent of volume on some days. That has made the industry pay new attention to these instruments.

"Everyone is looking to support ETFs because they are 40 percent of trading volume," said Dan McCabe, chief executive officer of Precidian Investments, which specializes in developing ETFs and mutual funds.

When the first ETFs were launched 18 years ago, they were handled by former options traders who had to cut their teeth on the floor of the American Stock Exchange. Expertise in portfolio pricing, portfolio management and indexing are important for trading ETFs, which is why many people who trade them today have a background in index arbitrage.

Traditionally, single-stock traders have rarely gotten involved with ETFs, but with these teenage instruments finally coming of age and taking their place as a dominant part of the industry, all traders are going to have to get schooled in ETFs.

There are now 1,300 exchange-traded products available, offering exposure to not just equities but commodities, currencies, futures, fixed-income and other asset classes. And more options are coming.

"With an ETF, you can now gain access to pretty much any asset class you need," said Dan Segal, who leads the ETF arbitrage business at Cantor Fitzgerald & Co. "We have to adapt, and we have to get more complex along with them."

According to recent data from Birinyi Associates, the top 10 ETFs by trading volume each month now track not just U.S. stocks, but also emerging markets equities, commodities, even the VIX volatility index.

Some of the biggest growth in ETFs has been from funds that track non-stock indexes, and Segal points out that GLD, which tracks gold, recently had more assets than SPY, which tracks the S&P 500. After market turmoil calmed down a bit, GLD's assets receded and SPY shot back up to number one.

As there are more and more ETFs trading non-equities, it brings up the question of who gets to trade the ETF. Briton Ryan, head of U.S. ETF sales and trading for Newedge, said while equity desks have traditionally had authority over ETFs, the vehicles can also be traded by those with the most knowledge of their underlying assets, whether commodities, bonds or something else.

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