ETFs set to take off locally.

Exchange traded funds (ETF) have gathered more press lately as their rollout in the local market gets closer. Jason Spits examines the growth of ETFs in the United States and their future development in Australia.

The idea of combining the capabilities of a number of products to create a new hybrid is well known in financial services. It involves much hard work and persuasion to get these ideas to market and is seldom the task of those past retirement.

However Nate Most decided to take on such a battle in his seventies and weighed into a five year effort to get ETFs onto the markets in the US.

Most, now aged 86 and a consultant with Barclays Global Investors (BGI) is widely credited with being one of the founding thinkers behind the creation and development of exchange traded funds (ETFs) within the United States.

The idea for ETF's was developed in the late 80's after Most became the head of new product development with the American Stock Exchange (AmSX), while most men his age were enjoying their retirement

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According to Most the exchange was squeezed for trading volume between the Nasdaq and New York Stock Exchange at the same time managed fund began their rise to prominence.

He says he did some work in creating an ETF for the exchange but it was judged to fall outside investment regulations.

However Most says after the 1987 crash the US regulators were more receptive to new investment products to provide safe investments in the lean times. Nonetheless it still took until 1993 for the funds to gain approval with the rollout of the now well known SPDR or "Spider" funds on the AmSX, which track the US S&P 500 Index.

Some of the first users of ETF were actually managed funds groups who purchased them in place of cash, and then redeemed the units in the ETF when the cash was needed.

This situation has changed slightly with many of those groups in the US now using ETF's as part of their regular portfolio mix. According to Most the total funds under management in ETFs is still 60 per cent held by institutional investors with the other 40 per cent covered by the retail market.

Since those first funds hit the market over 100 funds have appeared in the US alone as well as Asian and European offerings.

On the local front ETF's should be in the hands of investors by April with State Street Global Advisors (SSgA) set to have products available by then and BGI following at a later date.

According to SSgA international director of ETFs Gus Fleites its local offerings will tie in with Australian Stock Exchange (ASX) indices.

The agreement sets up the ground work for SSgA to offer funds tracking a range of ASX indexes as well as the All Ordinaries Index with the first product launched over the S&P/ASX 50.

BGI ETF manager Damian Holland says the group currently has 58 funds available, all of dubbed as iShares, in the US with 19 of those MSCI index linked country funds. The remainder of the funds are tied to various indices, dependent on the market.

"There is nothing a managed fund does that an ETF can not do, the major difference being of course that the fund is bought on a stock exchange and not through a fund manager," Holland says.

"In a volatile market, the lower cost of fees is important and the funds are wholly appropriate for fee for service planners."

Fleites says planners and advisers have been active players in spreading the ETF message in the US since they offer low levels of turnover, low shareholder activity while offering diversification at a low cost.

"Planners understand these are a good product for long term clients and consumers see the fees involved, which has driven some of the push into ETFs," Fleites says.

"For both parties they are an attractive product because they are cheap for consumers and planners can add a service fee and not be too expensive."

Holland says despite the rapid growth of ETFs, the funds are still weathering the education process with awareness still growing in the US and overseas markets.

"This is evident in that from what we have heard at least three companies are looking at setting up ETFs in Australia. In those markets where they are established there is still a lag in take up, compared with the US," Holland says.

According to a Morgan Stanley Dean Witter report on ETFs in the US that market has grown from US$1.1 billion at the end of 1995 to US$72.5 billion at the start of December last year.

The report says the market doubled in 1998 and grew by more than 60 per cent in the first half of 2000.

In Australia Fleites says growth may not be as steep but funds under management in ETFs should pass $2 billion in the first five years, with between $300 to $400 million invested in the first 12 months.

Most says much of this growth will come from the retail sector and should increase but will still be dependent on external factors.

"If interest rates continue to come down and we do have a soft landing or even a pick up in the markets this will have a positive effect on ETFs," Most says.

"Even at the moment assets under management are increasing on a weekly basis. The trend is not huge but it is moving and it will accelerate."

Holland says BGI has identified three phases in the products and is well into the second and is researching ways to move into the third.

"The first step was the initiation of the funds and the rollout of the first products while step two was to give the funds a wider focus and thus a wider market," Holland says.

"The next step is the development of new funds which seek to open up investments in sectors such as fixed interest. Equitising these types of sectors may lead to better markets for retail investors."

Fleites also says the roll out of ETFs across the globe is about increasing the retail participation in sectors normally not available to them.

"Up to now it has been difficult for average investors to get the exposure to the institutional side of the market," Fleites says.

"The definition of asset classes is being refined and investors wants tailored investments so I think ETFs will bring the institutional market downstream."