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.
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.
Coming Together
Rather then sparking turf wars, though, ETFs tend to bring different sides of a firm together, even though an equities trader and a commodities or bond trader might normally have little reason to collaborate.
"Generally speaking, it’s an opportunity for both groups to work together," Ryan said. "If you have the right management at your firm, they should be working to utilize the two specialties together to put out a better product to their customers."
For instance, if a large institutional investor wants to shift assets into GLD to gain exposure to gold, it could push up the price of the ETF. By taking advantage of a commodities desk’s expertise, a firm could instead trade gold futures or bullion and then create an equivalent product for the client at a lower price, according to Ryan.
And institutional investors are turning increasingly to ETFs. In a recent survey by Greenwich Associates, nearly half of asset managers and 32 percent of pensions, endowments and foundations said they planned to increase their allocations to ETFs over the next two years.
One of the biggest changes brought about by the ETF revolution has been the rise of ETF-specific desks, with traders dedicated not to stocks or bonds or commodities, but to trading a multitude of exchange-traded products.
"A specialized ETF trading desk has evolved at a lot of the firms with whom we work," said Kevin Quigg, head of ETF global capital markets at State Street Global Advisors.
That sentiment was echoed by Reggie Browne, managing director of the ETF team at Knight Equity Markets. Browne has been trading ETFs since the mid-1990s, and he said the trend is toward ETF-focused desks with ETF-specific traders. At Knight, retail flow still doesn’t go through the ETF desk, but all institutional orders do.
Browne said traders who just focus on U.S. cash equities are going to have to broaden their horizons if they value their careers-learning more about fixed-income, commodities, international stocks and foreign exchange. The days of the simple American stock trader are gone.
"The demand for services by those people is decreasing, and for someone to be competitive, they’re changing their skill sets," Browne said. "Demand shifts, and people look at new opportunities. They’re adapting themselves into other types of trading businesses. Fortunately, ETFs still land a career path for traders."
ETF traders generally need computer modeling skills so they can model the behavior of a basket of holdings. While computing skills are important, however, they do not outweigh the need to understand the traditional basics of trading.
For instance, Abe Kohen, director of trading strategies at FlexTrade, has both an MBA in finance and a master’s degree in computer science. To him, both sides are important.
"It’s the combination of the two of them that allows me to truly understand the instruments that we’re trading and how to get the best electronic execution," Kohen said.
Trading ETFs necessarily requires more of a quantitative or mathematical background than just trading single stocks. David Silber, head of equity derivatives at Jefferies & Co., said that’s because ETF traders need to have an understanding of how various stocks move together as a basket and relative to one another.
"Before, if you knew your stocks really well, that was good enough," said Silber. "Now it has to be more of not only knowing your stocks, but how they behave in a correlated manner."
Learning the Ropes
Fortunately, the learning curve does not seem to be as steep as it was for traders a decade ago. Silber said that in the last few years traders have become more sophisticated, in part due to concerted educational efforts by the industry.
Jefferies strives to continually educate its traders about what’s changing in the marketplace. Because ETFs have changed so much in recent years, Silber said about 20 percent of the firm’s educational efforts are now aimed at ETFs.
And education isn’t just necessary for traders on ETF-specific desks. All traders have to learn at least something about what has become clearly one of the hottest trading vehicles around.
ETFs have become so pervasive that they affect every institutional trading desk, according to Ken Marschner, head of U.S. quantitative trading for UBS.
While UBS does have ETF market-making desks, all of the financial giant’s traders are expected to be well versed in the world of ETFs.
"Pretty much all of our desks trade ETFs in different capacities," Marschner said. "Many different types of traders and desks have a use for these products."
The level of expertise a trader needs on ETFs can vary. Andy McOrmond, managing director of the ETF desk at WallachBeth Capital, said that traditional SPDRs don’t really trade too differently than cash equities. The problem is that second- and third-tier funds can act drastically differently, in part because liquidity can be more of an issue for ETFs.
According to McOrmond, an ETF that trades fewer than 2 million shares a day needs to be treated differently than an equity that trades fewer than 2 million shares a day. That’s because the makeup of market participants is so different.
"Arbitrageurs are not always inclined to post their best bids and offers on the screen," said McOrmond. "An equities trader needs to understand that there’s probably always a better price on an ETF than he’s traditionally seeing. He just has to find the right sources to go get it."
For McOrmond, the secret is a combination of learning what the ETFs are worth and who the proper players are in providing the liquidity. For more lightly traded ETFs, filling an order at the best price might then have to be done the old-fashioned way-with a phone call rather than a click of a mouse.
For these second- and third-tier names, trading desks might be strong in some areas but not in others. ETFs cut across a wide number of asset classes, and it can be impossible to find a desk that will give you the best price in ETFs for fixed-income, commodities, international equities, currencies and everything else.
"There are so many different asset classes now," said McOrmond. "It’s very hard to put together a shop of professional traders that are good in every single asset class."
In order to trade ETFs beyond the top hundred or so names, a firm needs to be able to go to different sources to get liquidity. But that takes much manpower and brainpower, especially when it comes to products a desk might only trade occasionally.
That’s why shops like WallachBeth have emerged as go-between firms for certain lightly traded ETFs. They act as a sort of broker’s broker, connecting other trading desks with liquidity at prices they might not normally be able to find.
"Traders have to do a good job on every single order, so they can’t drop the ball on an ETF order," McOrmond said. "That’s where ETF specialty shops like us come in."
Assets Soar
The importance of ETFs is growing as their assets continue to grow. Bank of New York Mellon has predicted that ETF assets will double to $2 trillion by the end of 2015. Others, including consulting firm McKinsey & Co., think assets could go even higher by then, topping $4 trillion.
According to Onur Erzan, a partner at McKinsey, ETF assets will rise to between $3.1 trillion and $4.7 trillion by 2015, with the growth coming from both retail and institutional investors. As many investors use ETFs as a substitute for individual stocks, there could be a boost in overall volumes, since trades in ETFs can trigger a second set of trades in their underlying securities, he added.
See Sidebar: Short-term Spikes, Long-term Growth
"If someone is to buy an ETF, they’re buying exposure to what’s in that ETF," said Chris Hempstead, head of ETF trading at Cowen Group. "The exposure doesn’t come from nowhere. Someone does need to trade the names that are in it."
Hempstead said the success of ETFs in past years indicates a greater percentage of new money coming into the market will likely flow into ETFs as opposed to mutual funds or single stocks. He sees ETFs continuing to gain market share in the future.
Mark Esposito, chief executive officer of Dallas-based Esposito Securities, said he could see ETF assets topping $4 trillion even sooner than 2015. He notes a lot of bigger money managers have gotten into the ETF game as investor appetite has increased. Ultimately, however, the shift to passive ETF investing could hurt research shops, he said.
"If they’re writing research on individual stocks, but everyone’s buying baskets, who cares?" said Esposito. "Unless it’s an active strategy, they’re not going to buy or sell an individual name based on research."
Of course that doesn’t mean research is going to go away. It just means we could be entering a period where the demand for research won’t be as high as it once was.
UBS’s Marschner said the shift towards passively managed investments reflects the fact that markets have gotten more efficient. If too many investors adopted passive strategies, it would create new inefficiencies, attracting money back to active management.
"There’s always a market for research and trying to generate alpha," Marschner said. "The reality is, if things shifted too far, and everybody was trading in passively managed instruments, it actually would make the bar lower in order to generate alpha."
Create or Redeem
Though indexes have to be rebalanced, the turnover in a passive ETF is a lot lower than for a normal managed strategy, so ETF growth could have a negative impact on volumes. However, some of that volume could be made up for by the create-or-redeem process through which underlying securities get packaged into ETFs or ETFs get turned back into their underlying securities.
The business of creating and redeeming ETFs is performed by authorized participants who make sure the fund continues to track its underlying index. If demand for SPY, for instance, outpaces a rise in the S&P 500, APs will buy the underlying stocks and sell SPY. If demand for the ETF drops, they will do the opposite.
But what sounds like a simple business can actually be quite complex. For instance, APs can create millions of dollars worth of fund shares through in-kind transactions in which a trade never hits an exchange.
"There are not a lot of people who are APs," Esposito said. "It’s very complicated for people to understand it, and even more complicated to trade it."
Joseph Cangemi, chairman of the Security Traders Association and head of equity sales and trading for BNY ConvergEx Group’s global electronic trading unit, agreed. He called APs the most sophisticated trading pieces of the ETF puzzle.
"From a standpoint of a single-stock trader transitioning into a viable part of the AP desk, the skill set has to be a lot more sophisticated than a single-stock broker," Cangemi said.
Due to the nature of their business, APs often have to take on a lot of balance-sheet risk, as well. Esposito said many large firms have gotten into the AP business due to client demand, but some of them would rather not be there at all. As ETFs become more important, however, firms that are proactive about their AP businesses could be rewarded.
Marschner said the primary reason UBS became an AP was because it needed to provide the best pricing for its institutional clients. Secondarily, though, it found the market-making business of an AP can be lucrative as well.
Cangemi was also sunny on the outlook for APs. He said the AP unit was one of the fastest growing businesses at ConvergEx.
The New Generation
ETFs launched today are looking less and less like the index funds of the past, according to Adam Gould, senior vice president for business development at DirexionShares.
"The plain vanilla passive indexing ETF market seems to have matured or is in the process of maturing," Gould said. "A lot of the products that I see coming to market now are commodity offerings that weren’t out there before, various fixed-income offerings that weren’t out there, some volatility strategies and other actively managed ETFs. So it seems to be a different kind of ETF that’s launching."
Greg Friedman, who spent years developing funds for iShares and recently became managing director of products for Russell’s ETF business, said that as ETFs have evolved, hedge funds have tended to be the early adopters of new products.
"They were huge adopters of fixed-income and commodities ETFs, because in the past they couldn’t get access to those markets cheaply and effectively," Friedman said. "It was an easy way for them to get in and out-to get the exposure intraday."
A recent study by Goldman Sachs found that hedge funds currently hold $125 billion in gross exposure to ETFs.
About 80 percent of hedge funds’ ETF positions are short, the report found. The study’s authors said the short bias in ETFs came because fund managers tend to use ETFs for hedging, not because they are taking directional bets on the markets.
Laura Morrison, head of U.S. exchange-traded products for NYSE Euronext, said hedge funds are a major driver of innovation in ETFs, frequently giving issuers their ideas about what new funds to launch.
"Hedge funds continue to be more and more active, and in the ETF space, issuers are paying close attention to what they have to say," Morrison said.
Newedge’s Ryan said ETFs don’t replace old-fashioned stock picking, but they do give investors more tools, which he sees as a good thing. Pension funds, for instance, might not have the resources to research and invest in certain commodities or foreign securities, but an ETF can still provide exposure to those asset classes.
"A lot of portfolio managers maybe didn’t want to invest in ETFs, but as the ETF space has grown and their competitors are outperforming using ETFs, they feel they need to get involved," Ryan said.
ETFs offer complex ways to trade for clients that traditionally had far fewer options. Bill Smalley, vice president for exchange-traded funds at Factor Advisors, said that only a few years ago it was difficult to invest in something like gold.
"There’s no question that ETFs have opened up asset classes to the masses that previously were difficult to own and to manage," Smalley said.
As more firms get in on the ETF game, however, margins have gotten thinner, according to Bob Tull, chief operating officer for Factor Advisors. He said the big, established desks are seeing aggressive new competitors.
Tull said some of these new, leaner firms have three to five guys doing the same thing that 20 traders on the ETF desk at a larger firm used to do.
Though relatively small, this new breed of ETF trading desks can have tremendous influence. That’s because they are interconnected to nearly every asset class there is. Tull said an ETF desk has tentacles that reach across the firm.
"It’s getting input from the foreign exchange guys, from the bond guys, from the international equity traders, from the derivative trading equity desks, the options guys," Tull said. "They’re becoming much more an expanded entity than the old silo trading desks."
Smalley said a lot of the trading desks he deals with are very much cross-functional. ETF traders today are neither equities traders nor traders of other asset classes. Instead, they are simply market traders, he said.
Short-term Spikes, Long-term Growth
One truism of exchange-traded funds is that when volatility goes up, use of ETFs goes up, too. In August as the stock market experienced multiple day-to-day swings, the notional volume of ETFs represented 36 percent of all U.S. trading, up from 30 percent in July, and continuing a long-term trend toward increased use of ETFs.
According to Laura Morrison, head of U.S. exchange-traded products for NYSE Euronext, the months leading up to the red-hot summer saw ETFs making up between 25 percent and 30 percent of the market.
Though there are occasional spikes in ETF use, the largest being in 2008 due to the financial crisis, the percentage of total volume made up by ETFs has been steadily increasing.
"You’ll always see ETF volumes spike during times of uncertainty, just because of the inherent liquidity, the inherent transparency," said Kevin Quigg, head of ETF global capital markets at State Street Global Advisors. "What you’re also starting to see is ETF volume as a natural occurrence throughout the capital markets system continues to rise."
As a result, more parties are becoming interested in making markets or being trading partners in the ETF business, according to Quigg.
"All of a sudden you have a marketplace where people that traditionally stayed within a finite set of ETFs are expanding their horizons," he said. "And the industry-from a trading perspective-is just getting larger."
Stuart Rosenthal, chief executive officer of the ETF firm Factor Advisors, agreed. He said many firms are looking at ETF trading as a growth area.
"Your various desks on the street clearly are taking notice of ETFs and their growing percentage of the daily volume," Rosenthal said. "I think it’s hard, increasingly hard, for those desks to ignore ETFs."
See Sidebar: Europe Lags Behind
Though ETFs seem to have conquered the U.S. market, the same is not true of Europe. Steve Grob, director of group strategy for Fidessa, said it can be difficult to get liquidity for ETFs in Europe, in part due to the fragmentation of the markets.
"Such ETFs as there are, are traded across a bunch of different European venues," said Grob. "An ETF based upon the largest European companies will be traded in London, in Frankfurt, in Paris, but it’s quite hard to see a combined view of the total liquidity available."
According to Grob, ETFs are growing in Europe, particularly in the Netherlands and the United Kingdom, but it will take years to catch up with the U.S. As ETFs in Europe gain more liquidity, however, they will grow more rapidly, as they do offer some clear advantages, he added.
The consolidation of exchanges has helped the liquidity problem in Europe. NYSE Euronext now owns the bourses in Paris, Amsterdam, Brussels and Lisbon. Laura Morrison, head of U.S. exchange-traded products for NYSE Euronext, said investors can now instantaneously access liquidity for ETFs in Paris, Amsterdam and Brussels, with Lisbon also coming online soon.
With the ETF market on the other side of the Atlantic looking up, several U.S. issuers of ETFs are now exploring ways of expanding into Europe, Morrison said.
"They’ve had success here in the U.S., and they know that globally ETFs are building momentum in terms of interest levels by traders and investors," she said.
Europeans might be forgiven for their shyness over ETFs, however. Kweku Adoboli, the alleged "rogue trader" at UBS who was arrested in London last month after supposedly losing $2 billion, worked in the bank’s ETF business.
