Major Growth Trends Continue... Doubling ETF Assets By 2015 (BK, BX, STT, SIL, GDXJ, VOO, AMLP, ELD, REMX)

At the end of 2010, US ETFs held assets of $1.005 trillion. By the end of 2015 that number will more than double to $2.091 trillion. That’s a compound annual growth rate of 15.8%, which is lower than the CAGR from 2005 through 2010 of 27.2%.

The data is included in a new report from Bank of New York Mellon Corp. (NYSE: BK) and research firm Strategic Insight.  The next wave of growth in exchange-traded products, including ETFs and ETNs, will come from the development of new asset classes, new indexes, and new uses for ETFs in building portfolios.

The report notes that ten ETF managers control 95% of ETF assets, and just three control 83% of assets: Blackrock, Inc. (NYSE: BX), State Street Corp. (NYSE: STT), and Vanguard.

The report states that the financial crisis has pushed investors away from traditional asset allocation models and made them increasingly willing to try new ways of managing risk and reducing volatility. ETFs that target emerging markets, commodities, and other non-traditional investment categories are now driving portfolio models. In March 2006, US equities accounted for 69% of assets in US ETFs. That number has fallen to 49% in March of 2011.

That new diversity in investment is one of the strongest selling points of ETFs. The report estimates that about half of the current $1 trillion in assets is held by institutions and the other half is held by retail investors. ETFs have also increased their share of the combined ETF-mutual fund market, from 5.2% of assets in 2007 to 8.8% at the end of the first quarter of 2011.

Another advantage of ETFs is that their expense ratios are usually “significantly” lower than those of mutual funds: “U.S. equity mutual funds average 82 basis points, versus 30 basis points for ETFs, while taxable bond mutual fund expense ratios are 68 basis points versus 27 for ETFs.” ETF investors are also willing to pay higher expenses for the more complex, innovative products offered by ETF fund managers.

Expense ratios among ETFs have also fallen because fund managers are willing to trim profit margins in an effort to gain share. The report points out that some brokers treat ETFs as loss leaders and use them to attract and retain customers and not as profit-makers. Commission-free trading could become the norm in the industry, helping it to grow even more.

The types of ETFs that are being offered now have begun to address very thing slices of the market. Think of the Global X Silver Miners ETF (NYSE: SIL) or the Market Vectors Junior Gold Miners ETF (NYSE: GDXJ).

According to the report, the five ETFs attracting the most new inflows in the 12 months to March 2011 are the Vanguard S&P 500 (NYSE: VOO), the Alerian MLP ETF (NYSE: AMLP), the WisdomTree Emerging Markets Local Debt (NYSE: ELD), the Global X Silver Miners ETF, and the Market Vectors Rare Earth/Strategic Metals ETF (NYSE: REMX). Combined net inflows for these five reached nearly $3.6 billion in the 12 months, and their combined assets totaled $3.84 billion at the end of March 2011. That’s some growth.

Another type of fund that has grown rapidly is the leveraged and inverse ETFs, which now hold assets of more than $30 billion. And actively managed ETFs have generated the most interest, if not yet the most money. The so-called active ETFs offer money market alternatives and some use derivatives to track currency and bond market movements.

The good news for ETF managers is that in 2009 only 5% of households that held mutual funds also held ETFs. There is room for very large growth here if the ETFs can break into the $4.5 trillion defined contribution market. There are some technical hurdles here, but the report claims that the biggest hurdle is the lack of understanding of ETFs and how they work. Target-date ETFs currently dominate the defined contribution ETF space in proprietary, single-firm funds.

To say that the BNY report is bullish on ETFs is an understatement. The amount of innovation, particularly in active ETFs and, in Europe, synthetic ETFs, raises some issues of the safety of these investments. This is another time when investors must understand thoroughly what they are getting for their money.

Paul Ausick