Expect More Innovation in ETFs in 2011

Emerging markets and fixed income are two areas that are particularly fertile ground for useful new products in the ETP space

Ben Johnson 26 January, 2011 | 12:34PM
Facebook Twitter LinkedIn

Looking further forward into the New Year, one thing that investors can know for sure is that 2011 will witness ongoing innovation within the market for exchange traded products (ETPs). While there will undoubtedly be ETPs brought to market covering new territory across all asset classes, there are two areas that are particularly fertile ground for useful new products: emerging markets and fixed income.

ETPs tracking traditional emerging markets benchmarks, most notably the MSCI Emerging Markets index, were tremendously successful in attracting new investor capital in 2010. (Read more in Could the Flood into GEMs Submerge Investors?) As the developing world crawls out of recession, emerging economies have sprinted ahead. But GDP growth does not necessarily translate into equity market appreciation. While it may seem counterintuitive that a nation's stock market may not benefit when GDP growth is strong, historical evidence points to a weak correlation between the two factors.

In a study of the link between economic expansion and the health of equity markets, University of Florida finance professor Jay Ritter compared the market returns and GDP growth of 32 countries from 1970 to 2002, and concluded that there was little correlation between the two variables. For example, the Swedish equity market posted average annual returns of greater than 8% during the period in question, while the Nordic nation's GDP compounded at less than a 2% annual rate. And the opposite is equally true; strong GDP growth doesn't guarantee strong equity returns. South Korean GDP grew more than 5% per year from 1988 to 2002, while its stock market registered annualised returns of just 0.4%.

2010 proved no exception to these findings. The Economist forecasts that China, Brazil, and South Korea--the top three economies represented in the MSCI Emerging Markets index--grew by 10.2%, 7.5%, and 6.1%, respectively in 2010. Meanwhile, the Shanghai Composite index, Bovespa, and KOSPI posted respective performances of -14.31%, 1.04%, and 21.88% for the year.

Going forward, we believe that there is a need for ETFs tracking small capitalisation emerging market equity indices to allow investors to better capitalise on these countries’ internal growth. Borrowing an example from the U.S. ETF market, we can see evidence for this in the recent relative performance of the iShares MSCI Brazil Index and Market Vectors’ Brazil Small-Cap ETF (BRF). Since the small cap product was launched in May of 2009, its price has soared 158%, versus a 61% cumulative increase for the iShares product.

The iShares ETF (IBZL) tracks the MSCI Brazil index and, as such, has a great concentration in large energy and basic resources names like Petrobras (PBR) and Vale (VALE)--whose prospects are perhaps tied more closely to China’s voracious appetite for resources than domestic Brazilian consumption. Meanwhile, Market Vectors’ small cap ETF provides a better way to capitalise on growth within Latin America’s largest economy, providing diversified exposure to a wide array of more locally-focussed public firms ranging from domestic property developer Gafisa (GFA) to healthcare diagnostics company Diagnosticos da America. A suite of region- and country-specific small capitalisation emerging markets ETFs would be a welcome addition to European investors’ toolkit.

We know for a fact that we will see a slate of innovative new fixed income ETFs come to market in 2011. ETP provider Source announced in December of 2010 that it is teaming up with the renowned fixed income team at PIMCO to deliver a series of actively and passively managed fixed income ETFs to investors. PIMCO’s Enhanced Short Maturity Strategy ETF (MINT)--the largest actively managed ETF in the US with circa $800 million in assets--has been a tremendous success and is widely used as a money market alternative. A similar money market-like vehicle in Pimco Source’s new lineup will likely not only attract new assets to the ETF category, but also steal assets from existing money market and short duration fixed income ETFs. (Read more in PIMCO Source Fixed Income ETFs Now Available.)

Further along the maturity spectrum, there is ample opportunity for a savvy fixed-income manager like PIMCO to add value with actively managed fixed income ETFs. The existing stable of longer duration corporate and sovereign bond ETFs are linked to rigid rules-based indices that were designed with benchmarking--not investing--in mind. Breaking with the credit ratings restrictions, capitalisation weightings, and other inefficiencies inherent to traditional bond benchmarks should allow PIMCO Source to bring a one-of-a-kind, low-cost offering to the table for investors. Indeed, as far as we are aware, the PIMCO European Advantage Government Bond Index Source ETF that came to market on January 24 is the first fixed income ETF in the world to be linked to a GDP-weighted index rather than a market-capitalisation-weighted benchmark. The cost of such innovation, however, comes in the form of a TER higher than the average charged by ETFs offering exposure to the eurozone government bond market.

A version of this article was first published in Investment Adviser on January 17, 2011.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Modern Slavery Statement        Cookie Settings        Disclosures