Exchanges can benefit from investors' growing appetite for products that offer diversified risk, tax efficiency and cost effectiveness.

IF MANY FUNDS under perform the index they are benchmarked against, why not invest in the stocks that make up the index? That thinking has led to exchange traded funds (ETFs) becoming a mainstay of many portfolios. Consequently, exchanges have an opportunity to introduce new products and to generate revenue.

Although the SPDR (NYSEAMEX: SPY), a widely held ETF which allows investors to buy or sell the S&P 500 with one trade, started slowly in 1993 and had to be re-launched, it eventually became successful. Its popularity led to the launch of ETFs on other indexes, including the PowerShares QQQTM (NASDAQ:QQQQ), which tracks the NASDAQ-100®, and the Diamond on the Dow Jones Industrial Average (NYSE:DIA).

Today, ETFs are offered on an array of asset classes including gold, other commodities, currencies, fixed income securities, industrial sectors or specific countries. Currently numbering around 690, about 200 new ETFs were registered and started trading in the US in 2008.

^{Map represents number of ETFs per country.  Source: ETF Research & Implementation Strategy Team, Barclays Global Investors, Bloomberg} 

While the US is the largest ETF market, they are also popular in Europe and the Asia-Pacific region, particularly in Japan and South Korea. A new iShares Asia ETF Series was recently launched in Hong Kong that includes four new funds designed to provide access across the region. In Europe, ETFs were first launched in 2000; today there are about 672 ETFs from 29 providers listed on 21 exchanges.

John Jacobs, Executive Vice President and Chief Marketing Officer at NASDAQ OMX explains the advantages of ETFs over mutual funds. “Because mutual fund transactions are priced at the end of the day, investors cannot take advantage of intra-day moves. ETFs can be traded like a stock. Investors can buy and sell them during the day, set up a margin account with their broker, and take short positions. Investors can visit the provider’s web site and know their exact holdings daily. With a mutual fund they may only see the holdings quarterly."

INVESTORS ALSO choose ETFs because of their tax efficiency. At the end of 2008, many US investors holding mutual funds were hit with capital gains distributions and declining portfolio values. “ETFs are generally more tax efficient than mutual funds because of the in-kind creation/redemption process,” says Benjamin Fulton, Executive Vice President, Global Product  Development at Invesco PowerShares. “The PowerShares family of equity and fixed income ETFs did not distribute any capital gains to investors during 2008, and in fact have not made any capital gains distributions since inception.”

ETFs allow investors to spread their risk. For instance, they might think the financial sector is undervalued, but instead of hoping that the few banks they select are the right choices, investors can buy the financial SPDR or another financial themed sector ETF.

“While, they may hit some potholes along the way, they’ll live to fight another day,” says Scott Burns, Director of ETF Analysis at Morningstar. “The whole sector would have to go the route of Lehman Brothers or AIG to get wiped out.”

Fixed income and commodity ETFs have attracted fund flows from investors wary of the stock market. Statistics from the Investment Company Institute show that assets in bond ETFs increased 42%, and commodity ETF assets increased 30% between March 31, 2008 and March 31, 2009.

THE GROWTH IN the ETF market presents opportunities for exchanges to introduce new ETFs and related derivative products. Investors and traders hedge ETF positions with futures and options. The QQQ and the SPDR are popular ETF options, alongside the NASDAQ-100 and the S&P 500 Index Options, as are the CME futures contracts on those ETFs. “We see an increased demand for new indexes on which to base ETFs and have, in fact, successfully launched a new global index feed for our 1500 indexes that reach 900 global vendor customers,” says Magdalena Hartman, Vice President, NASDAQ OMX Global Index Group.

New revenue can be generated through the sale of market data, calculation services and index licenses. The NASDAQ-100 stocks trade side by side with the QQQ. Traders need an additional data stream to look at the underlying securities and the Intraday Portfolio Value (IPV) in real time. The IPV is a real-time calculation of the ETF components, but it is different rom the index because of the way the basket is put together. The QQQ equals 1/40th of the index, so if the index is at 2000, then the QQQ is $50. Moreover, a cash component is mixed in with the basket of assets reflecting dividends received. Therefore, traders need to receive the data stream of the stocks, the indexes and the IPVs simultaneously.

ETFs may be the most innovative investment vehicle of the last two decades and have changed the way investment managers construct portfolios. Retail and professional investors have increased their usage of ETFs during this difficult period. And, as the market stabilizes, the ETF assets and the marketplaces that trade them are positioned for growth.

by Sherree DeCovny illustration Johan Nohr