ETFs could face a number of hurdles in the coming year.
You probably won't be surprised to hear that institutions dominate the scene when it comes to exchange traded funds (ETFs).
According to the latest London Stock Exchange stats, reported daily trading in ETFs (and exchange traded products) averages roughly to 4,450 trades and the average daily value of trades is in the region of £300 million. This gives an average trade of just under £70,000.
Compared with 18 months previously, both the number of trades and the amount traded has risen significantly. However, there has been a modest (9%) decline in the size of the average trade. Despite this, the overall picture seems to be that institutional trading of ETFs not only dominates the market but will continue to do so.
In terms of the number of institutions trading, it looks as if this year's level will show a return to growth after the dip in numbers in 2008. The kinds of institutions that are most interested in trading ETFs are asset managers, private banks and hedge funds.
What about private investors?
As for smaller investors, research published at the beginning of December showed that in the UK less than 10% of independent financial adviser (IFA) clients had had ETFs recommended to them by their adviser.
The FSA appears to be on the case with its recent opinion that advisers should be recommending (or, at least, considering recommending) ETFs to their clients. My view is that this, and the abolition of advisers' commission, may have less effect on ETF investing than expected.
For advisers, with their fiduciary duty to their clients, recommending active funds, which have a duty to maximise returns, fits in well with the rhythm of periodic client portfolio reviews.
Passive ETFs only have one duty; to track their index. Deciding whether or not an ETF tracker investment is in the best interest of their client, appears to leave financial advisers with a lot more work to do while the investment is held.
Looking to the future
For smaller investors, who do their own research and invest autonomously, ETFs make much better sense. But, given the importance of institutional investors in ETF trading, are there any likely trends that could adversely affect smaller investors?
The first likely trend for 2010 is a continuation of the off-exchange/multi trader facility (MTF) trading in ETFs. The Chi-X, Europe's largest MTF, saw a 270% rise in its ETF trading in the first 9 months of 2009 and is now and is now Europe's 8th largest market.
At some point, it seems likely that rises in off-exchange trading is going to begin to reverse the increase in on-exchange ETF trading. If trading volumes start to decline, bid-offer spreads might begin to widen for ordinary private investors. Arguably, the same could happen with individual shares as well.
Secondly, with most investors, institutional or otherwise, expecting the economic recovery to be 'W' or 'U' shaped, financial institutions still needing more capital and an end to fresh quantitative easing, 2010 is not looking like a good year for investors.
In these conditions, I suspect a surprising number of ETFs could face the axe. Investors would do well to check out assets under management and trading volumes to avoid investing in funds in danger of being wound up.
Thirdly, the current uncertainties about government bonds and their credit ratings mean that smaller investors need to be extra vigilant with fixed income ETFs and, in particular, timing purchases and sales with care.
Obviously, sovereign debt crises could lead to volatility in the price of the underlying assets of some fixed income ETFs and, in extreme cases, a breakdown in the fixed income indices through liquidity problems.
Whether one's invested in fixed income ETFs or not, I reckon it's probably best to sit tight while an institutional elephant stampede is in progress. Institutions' trades may make an ETF look liquid for the time being but that's no guarantee for the future.
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