From DOG (AMEX:DOG), an inverse index fund from Proshares, to DOO (NYSE:DOO), an international dividend-focused fund from WisdomTree, the exchange-traded fund (ETF) market is exploding with new offerings. Hopefully, these two funds won't end up with performance that matches their combined names.
The growth in indexed products in general has been a boon for ETFs. The usual suspects are driving ETF expansion: broad diversification, low expense ratios, high tax efficiency, trading flexibility, and most importantly, performance. Here's a quick, Foolish overview of the ETF market.
ETF sponsors
Barclays Global Investors, the firm that created the first index strategy in 1971, is the biggest ETF sponsor, with more than 125 funds. Barclays currently holds a commanding 50% of the market, with about $225 billion in total assets.
State Street Global Advisors developed the very first ETF, the SPDRs (AMEX:SPY), in 1993, but it's failed to fully capitalize on that early lead. It now manages only about one-fourth of all ETF assets, or roughly $90 billion.
After the two ETF giants, the remaining market share is split between roughly a dozen firms, ranging from traditional mutual-fund powerhouses like Vanguard and Fidelity to newcomer PowerShares Capital Management. Despite its rookie status, PowerShares is quickly carving out its niche, listing more than 30 new funds in the United States in 2006.
In the late fall of 2006, the Nasdaq (NASDAQ:NDAQ) announced a deal to transfer the sponsorship of the Nasdaq-100 Index Tracking Stock (Nasdaq: QQQQ) to PowerShares. Though the fund is one of the most widely traded ETFs, with about $18 billion in assets, Nasdaq wants to focus instead on its core business of creating indexes. The deal will vault PowerShares into the ranks of the top ETF sponsors, and it's a further indication that distribution and support, not just products, will continue to grow in importance for ETF sponsors.
Concentrated assets
Although there are many new and interesting ETFs, the market is highly concentrated. SPY and EFA (AMEX:EFA), an ETF that tracks the MSCI EAFE Index, are ETF giants, with $65 billion and $32 billion in respective assets; the venerable QQQQ is the market's third-largest fund. On another measure, SPY and QQQQ combined account for more than 50% of ETF trading volume. As the variety and number of funds increases, investors have moved their money into some of the new choices, but the old stalwarts still hold the bulk of assets.
New investment options
The old saying about the weather -- if you don't like it, just wait a bit -- applies equally well to ETFs. If you don't like the current offerings, have patience; a fund meeting your needs should appear soon. There are now nearly as many funds in registration with the SEC as there are currently on the market.
Rydex Investments currently has 24 ETFs in the market, including seven currency shares. Rydex is well known for innovation, having debuted the first inverse equity fund and fixed-income mutual funds. It now has 96 ETFs on file with the SEC, ranging from leveraged funds to those designed to run counter to their benchmarks.
ETF newcomer WisdomTree Investments has also filed with the SEC to launch 31 new "fundamentally weighted" funds. The offerings will track indexes of sectors and REITs, along with dividend-rich foreign stocks and other areas.
PowerShares Capital Management has also joined the line at the SEC, filing 35 ETFs with the agency, primarily focused on international stocks and single-country funds.
Not your father's ETF
Older ETFs tend to be based on market-cap-weighted indexes. The newer ETFs are trying to move beyond this to include fundamentally weighted, equal-weighted, and theme-weighted indexes as well. While many new funds push the envelope of active management, passively managed ETFs tend to be more tax-efficient than more actively managed funds.
Some of the newer indexes haven't been around long, so it's too early for investors to know whether they're smart investments. The new funds following these indexes may have many merits, yet a lot of these funds and indexes still haven't proved their worth yet. Some fund companies are only able to present backtested or simulated performance assumptions. Backtesting may look nice, but it's not real-life historical performance, and it may not accurately reflect future trends.
Institutional investors and traders were early adopters of ETFs, but now individual investors and financial advisors increasingly view ETFs as long-term alternatives to both traditional index funds and actively managed funds. Still, investors should beware the higher fees, greater turnover, and potentially larger tax hit from some of the new ETFs, compared to their more veteran counterparts. Foolish investors should also know the investment objective, design, and structural differences of an ETF and its index before committing money.
The ETF market may contain DOG and DOO, but it also holds funds like the PowerSharesHighYield Dividend Achievers (AMEX:PEY) -- an investment that we can only hope will live up to its ticker symbol, over and over again.
Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own shares in any of the funds or companies mentioned in this article. The Motley Fool has a disclosure policy.
