By Gavin Quill, Financial Research Corporation

If S&P 500 index funds were the most notable success story from 1996-1999 and technology funds were the talk of the industry in 1998-1999, then their headline-grabbing successors in 2000 were probably index-based exchange-traded funds. After seven years of relative obscurity, modest asset growth, and stagnant product development, these innovative hybrid instruments finally exploded onto product development radar screens in 2000.

Just 12 months ago, there were only 30 ETFs registered in the U.S. (excluding Merrill Lynch HOLDRS). Only 13 of these focused on domestic equities. Today there are 78 different portfolios available to any investor with a brokerage account, and the number of U.S.-equity ETFs has increased more than three-fold to 54.

While the number of funds has risen by 160%, total ETF assets have increased by 86% to nearly $63 billion, up from less than $34 billion at the end of 1999. This growth rate is particularly impressive given the sizeable depreciation experienced by many equity markets this year. FRC is not aware of any other major financial product category that came close to matching the asset growth rate of exchange-traded funds in 2000.

Source: Financial Research Corporation

Market Concentration

Despite these tremendous growth achievements, the ETF industry remains extremely concentrated no matter how you look at it. The American Stock Exchange controls essentially 100% market share in terms of both listings and assets. The New York Stock Exchange and the Chicago Board Options Exchange are just beginning to very cautiously experiment with their own limited offerings, and every other domestic exchange is completely inactive in this area.

The AMEX has a tremendous head start over the NYSE, and has now established a clear track record of success that should prove compelling to the plethora of new asset managers expected to bring their products to market over the next two years. By the time the NYSE begins to build traction with index-based ETFs, it is likely that the AMEX will have raised the product development bar even higher with the introduction of an actively managed version.

While there is only one exchange actively involved in trading ETFs, there are really only two asset managers in the U.S. that are meaningful players in terms of sponsorship. Barclays and State Street Global Advisors are not only the long-term pioneers of the ETF world, but also the only institutions to actually bring new products to market in 2000.

Barclays introduced 39 new funds during the May-July period, while State Street rolled out nine portfolios at the end of September. Barclays’ massive product development effort has transformed the ETF landscape by creating alternatives in just about every investment category necessary to complete a robust asset allocation model.

This milestone now means that financial advisors can construct an entire portfolio with low cost, tax-efficient, and trade-flexible ETFs instead of mutual funds. In many cases, advisors will also opt to eliminate much of the burden of individual security selection and enjoy the instant diversification of ETFs, now that a complete range of products is finally available.

Concentration in ETFs

Concentration in the exchange-traded fund industry goes beyond exchanges and sponsors to include the ETFs themselves. While there are now 78 portfolios available, the overwhelming majority of these are still quite small, and there remains some question in the minds of certain observers as to their long-term viability.

Just two funds (SPDRs and Nasdaq-100) represent 77% of total U.S. ETF assets. If we include the other three funds with at least $1 billion (Mid-Cap SPDR, iShares S&P 500, and Diamonds), we find that the top five funds control 89% of assets. There are only 14 other funds with assets greater than $100 million. This leaves 59 funds that collectively hold only $2.7 billion, or an average of $45 million each. Of these, 38 currently hold less than $50 million.

FRC believes that the explosive growth experienced by ETFs will continue into 2001, with the entry of many new sponsors (particularly Vanguard), the emergence of the NYSE, the probable creation of enhanced and leveraged ETFs, and the possible creation of fixed-income ETFs.

Beyond that, 2002 will likely see the long-awaited rollout of actively managed ETFs. Over the next five to seven years, FRC believes that total ETF assets could reach as high as $500 billion. We expect that ETFs will be making headlines for many years to come.

01/24/2001

This article originally appeared in the December 2000 edition of FRC Monitor, a publication by Financial Research Corporation, and is reprinted by permission.

Gavin Quill is Senior Vice President and Director of Research Studies at Financial Research Corporation (FRC). Gavin oversees the research and writing of comprehensive primary-source studies related to a wide variety of mutual fund industry topics. Gavin also serves as a senior consultant, helping FRC clients develop and implement a broad range of strategic initiatives.