December 20th, 2011 by Scott Burns

9 Things We Learned About ETF’s in 2011 Transcript from video of Scott Burns

Taking a look back at 2011 in ETFs.

Hi there! I’m Scott Burns–Morningstar’s director of ETF, closed-end fund, and alternatives research–here to talk a little bit about what we learned in 2011 in the ETF space.

I think the first thing that we learned and saw is that ETF adoption continues unabated. Flows remain generally positive in every month, and we continued to see more and more adoption and more and more mainstreaming of ETFs as core portfolio holdings and also as tactical training tools.

The other thing that we learned about ETFs, and I would say investing in general in 2011, is that risk is everywhere. There was a lot of discussion about derivatives in funds or synthetic ETFs in Europe, all of it on the backdrop of the continuing liquidity and banking crisis happening in Europe. At the end of the day, risk is everywhere, and risk equals return.

So, one thing I think we learned is that people are very risk-averse right now, but also that there is a problem in the dialog that all risk is bad. And that’s not true, because risk has to equal return. So, if you don’t want any returns, then you won’t take on any risk. But if you do want some returns in your portfolio, you have to take on some risk to do that. Keep in mind that there are no riskless returns, but there are returnless risks, and you need to be able to separate the two.

Staying with that risk theme–one of the big trends and one of the larger areas of success in new-product launch in ETFs in 2011 was low-volatility products. We saw tremendous amount of inflows into low beta, low volatility strategies where investors are clearly looking to tamp down market volatility, while still getting some equity risk and therefore equity return.

Another one of those themes that kind of falls into this: low-volatility and income actually kind of sit side-by-side, but income was one of the huge drivers in ETF new product launch success and general flows overall. Dividend-themed income funds, low volatility funds which kick-off a nice dividend stream. Also dividend-themed income funds that move beyond just U.S. large-cap dividends, but also international. Huge growth drivers in that area, lots of interest going on in 2011. Investors–especially, ETF investors–clearly are looking for income.

On that theme of income, one of the other more interesting trends is the move into non-U.S. debt. Two of the most successful launches over the past 12 months were ALD and ELD, that’s … East Asian denominated bonds and emerging-market bonds. Massive growth, massive interest. The U.S. investor is also looking to diversify their fixed-income portfolio away from traditional dollar-valued bond areas and into some of these more diverse, different currencies and really different economies and different government backing those things.

Another trend that we see in 2011 is actually the arrival or the continued arrival of the alternative tool ETFs. Now, what do I mean by that? Well, there are alternative funds that are core holdings, things like a merger-arbitrage fund that you would hold in a diversified alternative sleeve of your portfolio. But what we really saw in 2011 is the continuing launch of these very specific, risk-mitigating tools or exposure tools. Things like the factor-products launch by Russell and continuing launches in VIX products, in other products that help to manage duration risk on the fixed-income curve. None of these ETFs are really designed to be held per se forever or as part of a core, but they are meant to be tools implied to reduce risk or fill out exposure gaps that we see out there. So, we continue to see that evolution. I think a lot of people forget that the first ETFs, back in 1994, were the on-exchanging of a very simple structured product. And what we’re seeing now is the fifth and sixth generation of structured products moving onto the exchange. … A lot of these funds and the techniques they employ have been used by institutional investors for years, if not decades. And now they are moving onto the exchange in a low-cost way for investors of all sizes to be able to employ in their portfolio risk management.

One of the other things I think that was most notable in 2011, is that there was a lot of noise about ETFs … creating market volatility or raising correlations, and that’s true whether it was just regular ETFs or leveraged ETFs, in particular. So, one of the things we learned was that in 2011 we had a Congressional hearing based on a lot of these accusations more or less, and the funny thing is, nobody showed up to it. One congressman showed up, or maybe it was a senator, showed up to the hearing; no other congressional members showed up. We had testimony from the NASDAQ exchange, BlackRock iShares, and a member of the SEC. None of it was really new information. Actually, I think a lot of it confirmed that ETFs are not the cause of volatility. I always want to make sure investors know that Occam’s Razor is something that really holds true here when you are looking for sources of volatility. The simplest solution is probably the best, and maybe it’s just that everybody is really freaked out right now, and that’s why markets are so volatile.

We also learned that price continues to matter in ETFs. We saw Vanguard usurp BlackRock products in several large categories. We’ve also seen fund companies and ETF providers cut their fees in order to make their products more palatable and more usable. We’ve also seen the entrance of some more low-cost [providers] with Scottrade’s FocusShares, most in particular entering that. And in full disclosure, FocusShares does base … a lot of their index products on Morningstar-produced indexes.

So, price continues to matter. We continue to see money flow to lower-cost … options. But what we learned in 2011, as well, is that while expense ratio is important, we want to make sure people understand that that’s just part of all the costs that go into it. And you have to think about the liquidity effect, and you also have to think about tracking error and tax efficiency when we look at the total ETF cost structure that’s out there.

Last but not least in things we learned in 2011 is that ETFs are evolving, and the use of ETFs is evolving in a major way. What I’m talking about here is the use of ETFs in solutions, and that is managed portfolios.

We recently started a new database tracking, in the separate account space, ETF managed portfolios. These are funds or active strategies, more or less, that are using ETFs. So, in a weird way, it’s active with passive. And so, we’ve seen these funds grow tremendously. When we look at our database, we have about 333 strategies there. But the most amazing thing about these ETF managed portfolios, or these portfolio solutions in general, is that the AUM growth this year has been 52%. So investors are clearly saying, “I want ETFs, but I’m also looking for a more holistic solution.” I think it’s safe to say that when you look at that kind of asset growth, although it’s a fairly narrow scope, that that has to be one of the fastest areas growing in finance right now. So, even though it’s not specifically about ETFs, it’s about managers that are using ETFs, and they’re seeing tremendous growth with that.

So that’s what we learned in 2011. I’d love to see your feedback at the bottom of the video. And I look forward to having a great 2012 with everybody. Thank you.

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