Exchange-traded funds have been rapidly expanding into every nook and cranny of money management, from emerging markets to commodities. With more than 1,100 ETF products in the United States alone, (1,250 if you include their cousin, exchange-traded notes), one would think the ETF market is already saturated.

But the industry disagrees. How about technology companies in the emerging markets? No problem, there are ETFs for that. Or cloud computing? ETFs, yes. Bonds, commodities, currencies? Check, check and check. At this point each of the major market segments—large-cap, mid-cap, small-cap, every sector, every style and even most countries—are covered by at least one, and in many cases several, products. Even most emerging markets are well represented. "The broadest level is saturated," says Dan Brown, an ETF and closed-end fund analyst at Wells Fargo Advisors.

He is referring to so-called, plain-vanilla products, which simply track an index. Other ETFs offer variations on an index, such as using derivatives and leverage to aim to capture twice or three times a market's return, or the inverse of that return, so investors can make bullish or bearish bets. The ranks of these sophisticated products have been growing for years, and will likely continue.

With some $1.1 trillion in assets as of the end of July, ETFs are giving active managers a run for clients' money in what had been the fattest plum in money management: U.S. large-cap stocks. There is some debate about how much business this largely passive investment tool is stealing from active managers, but there is no debate about the industry's incursion into wider money management territory. Vanguard was the last major provider of ETFs to launch a plain-vanilla product at the end of last year, when it rolled out its ETF version of S&P and Russell equities indexes, tracking large, mid- and small-cap stocks. The giant's first entries, formerly named VIPERs, covered the MSCI indexes. (The company dropped the VIPER name in favor of the more widely known Vanguard brand.)

"We've sliced every index nine ways to Sunday," says Rhode Island-based industry consultant Geoff Bobroff. "Sure, new indexes will be created, but the real opportunity for gathering real assets in the indexed world has reached a pinnacle. We will see more growth, but the surge in interest is behind us," he adds. He is dubious about suggestions by ETF industry chiefs that it could double in size in the next five to seven years. "It depends on whether it makes sense for the market," he says. "These are very self-serving comments; they're knee-deep in product and they can only wish it to occur."




Indeed, now that the mainland has been settled, fund companies are busily looking to more esoteric shores. In 2011 alone, through the end of July, 202 new ETFs have been launched. That compares with 124 in the same period last year. Although iShares rolled out a bushel of ETFs tracking individual countries in the mid- to late-1990s, some of the smallest markets, such as New Zealand and Poland, are just now getting their own ETFs.

Drilling Down

Investors can also get sector-specific in some pretty narrow markets. For example, the Emerging Global Shares Technology GEMS ETF [QGEM], launched in June, has a mandate to invest in computing, Internet and telecom companies across the emerging markets. But Wells Fargo's Brown notes that it owns shares predominantly in Chinese and Indian companies. So even the most avid emerging-markets investor could wind up with more concentrated exposure than he bargained for.

Brown says that Emerging Global Shares also offers a consumer services ETF focused on the emerging markets that is more balanced. But the bottom line is advisors should always know what's under the hood. "Yes, it's broad emerging markets where they start, but ultimately because of the sector they're focusing on, you're going to see mainly China and India," Brown says. "So it's understanding where they start and where they finish," he cautions.

ETF providers have been looking for growth in other directions as well. As the market for broad market-cap-weighted products has become crowded, they've been moving into products with specific strategies that has long been the province of active managers. Dividend-focused strategies have been around for a while, but are now enjoying renewed popularity thanks to investors' appetite for income in a low interest rate environment. The original dividend-focused ETF, iShares Dow Jones Select Dividend [DVY], launched in 2003, shares shelf space with two other behemoths, the SPDR S&P Dividend ETF [SDY], which tracks the S&P High Yield Dividends Aristocrats Index, and the Vanguard Dividend Appreciation Index Fund [VIG]. DVY is more focused on companies within the U.S. equity market that have the highest yields, while VIG also includes companies that have been raising their dividends. SDY generally has a requirement that a company has to increase its annual dividend for 25 consecutive years, while VIG's requirement is a mere 10 years of consecutive growth. The big three hold assets of close to $19 billion.

Another large ETF provider, Wisdom Tree, launched a significant amount of dividend-focused ETFs, and PowerShares also offers some. With more than 40 offerings, the entire group holds assets of more than $30 billion. One tactic to expand away from basic index-tracking has been to get very, very specific. Capitalizing on investor fascination with cloud computing, First Trust, one of the top 10 providers of ETFs by assets, launched its ISE Cloud Computing Index Fund [SKYY] in July.

More Complex Mousetraps

Another popular strategy has been to try to build a better mousetrap. Commodities have probably seen the most attempts at innovation recently, due to investor demand. There are now more than 100 commodity ETFs and ETNs, with assets of more than $110 billion. Commodity ETFs have been around for a while, but can suffer a drag on performance for technical reasons. The drag, called contango, is basically buying high and selling low. It happens when a later-dated futures contract is more expensive than the futures contract approaching expiration. The manager of a commodity-tracking ETF has to pay the price differential to "roll into" the later-dated contract. Some providers think the solution is in a different product structure. ETNs, the cousins of ETFs, are debt instruments that do not have to follow the same rules. ETFs must own the securities underlying the index they are tracking. ETNs must simply track the performance of their index. So product providers began to experiment with ways to reduce or eliminate contango, introducing a slew of new ETNs with a variety of strategies.

They are catering to many investors who had hoped to get the spot price of oil through ETFs and were bitterly disappointed. Brown of Wells Fargo says points out that the traditional commodity ETFs were never intended to match the spot price of a given commodity. Even oil companies do not get the spot price for oil, because they have to pay storage costs. The original ETFs were meant simply to provide exposure to a commodity. Brown says that, as always, education is critical. "A lot of this is actually understanding the objective of the ETF and how they are achieving that objective," Brown says.

However, this batch of commodity ETNs is untested. And industry observers say it will take at least a full year to see if they succeed in reducing contango. There are other things to know about ETNs too. Because they are debt instruments, they come with the credit risk associated with the issuer, just like a bond. A unit of Barclays Bank called iPath is the largest issuer of ETNs. (The investor buying them is exposed to the credit risk of Barclays.) Brown explains that his group deems the risk of Barclays defaulting as "small," but added that investors should be aware of it, regardless. Furthermore, they get more complex tax treatment that could end up costing investors more.

Other new futures strategies include various ways to track the Chicago Board Options Exchange (CBOE) Volatility Index, known as the VIX. The VIX is used as a measure of market volatility, and often viewed as a gauge of investor anxiety. It is built from a range of options on the S&P 500 Index.

But product managers on Wall Street say ETFs can be a good tactical choice in some complex markets, such as commodities. "I think ETFs are being used as trading or hedging vehicles," says Peter Thatch, head of global funds at Merrill Lynch Global Investment Solutions. "Gold is a great example. It's an opportunity to get access to the asset class because you want beta and lower correlation, and you don't necessarily think it's an asset class where you'd want to pay for active management or alpha. I see it more as a complement to active management."

The numbers bear this out. Commodities are in the top five strategies in ETFs at Morgan Stanley Smith Barney, according to Paul Weisenfeld, head of the company's mutual funds and ETF business. He says that ranking is much higher than in mutual funds, where commodities fall between his firm's top 15 and 20 strategies.

The managers report that advisors are also using ETFs to fill out the traditional style box. This points to a trend that is taking a toll in some parts of the mutual fund industry. "In terms of style boxes, ETFs can be more popular because unless you think there's value in active management, you may just use the ETF to get exposure to the asset class," Merrill Lynch's Thatch says. "That's generally true in fixed-income as well, but when you get to some fixed-income strategies that are narrower in their focus, it may make sense to pay for active management there," he adds.

Weisenfeld and Thatch both say ETFs are used much more in the advisor program than in the brokerage platform—by a margin of two-to-one. Thatch further explains that although cost is a factor in deciding to use ETFs, it is not the only one. Advisors must determine when extra performance can be gained by paying extra for an actively managed fund and when the goal is simply to gain exposure to a particular market, and lower-cost ETFs are the way to go.

"That's where the FA adds value to his clients in giving advice," Thatch says. "I see it as much more complicated than looking at fees. There are guys who run ETF models out there, but I don't think better advisors run one or the other, they see the value in both," he says.

Advisors elsewhere on Wall Street seem to agree. At UBS, the fastest-growing product is a program that allows advisors with discretion over clients' accounts to use ETFs, mutual funds and individual stocks, says Ajay Mehra, the firm's head of manager and fund research for the Americas.

Looking Ahead

Analysts say the next big step for the industry will be actively managed ETFs. Industry observers and participants have been talking about this trend for more than a decade, and still no major ETF has emerged. (The relatively few actively managed ETFs that have been introduced have been too small to make a difference.) So it's no surprise that the industry is keen to see how the new ETF version of the biggest mutual fund in the world, PIMCO's Total Return Bond Fund, will fare when it debuts in the coming months.

The big stumbling block for an actively managed ETF has always been how to be transparent and avoid the problem of front-running. The Securities and Exchange Commission requires that ETFs make their holdings public daily. For managers of stock funds this is a problem because if arbitrageurs or other traders find out ahead of time what they intend to buy or sell, they can move in ahead of them. The result will be the fund getting a worse price for the security. Massive stock funds like American Funds' Growth Fund of America are especially vulnerable, because they can move share prices with a big enough buy or sell order, and traders watch them closely. Observers say PIMCO Total Return, even with just under $243 billion, isn't in the same danger as its stock brethren because front-running isn't as big a danger in the bond market. Further, they suggest that the fund is so large, and manager Bill Gross has always been so vocal, that the market has a fairly clear idea of what he owns anyway.

But even if front-running is not a problem for the PIMCO Total Return Exchange Traded Fund [to be TRXT], Bobroff says two questions remain: How well will it track the original fund? And will the markets object to differences in pricing? First, as to the tracking, it's an open question, because in its regulatory filing, PIMCO said the ETF's holdings will be similar, but not identical to its fund namesake. One difference is the ETF will not be using derivatives as widely as the mutual fund is able to do. Second is pricing. As to that, investors may well object. The management cost of the retail share class is 90 basis points, while the institutional share class costs 46 basis points. The ETF will be priced at 55 basis points. "Is this is going to create some stress with PIMCO and the broker-dealer community?" Bobroff asks. "Because why would a customer go into the A shares and pay arguably twice as much in expenses than buying the ETF?"

Regardless of how the actively managed ETF experiment turns out, observers say the industry will keep cranking out more and more complicated products. And advisors will have to spend serious time to learn how they work. "With specialized ETFs, the importance of not only understanding strategies, but also how they get to their result, is increased; and how to use them in a portfolio," Wells Fargo's Brown says. "The due diligence requirements for new ETFs have increased."

Elizabeth Wine is a frequent contributor to On Wall Street.
She writes about financial products and investment strategies.