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ETFs Forge Bonds with Investors - Flurry of Product Development in ETFs Creates More Fund Alternatives

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The debut of bond ETFs plus a slew of filings in the pipeline have elevated interest in ETF product development activity.

Barclays Global Investors, having brought the largest number of ETFs to the U.S. marketplace, is in the spotlight these days. After introducing the world's first bond ETF to Canada in 2000, Barclays finally cleared regulatory hurdles here in the States and launched four bond ETFs in July, which have generated much interest among various types of investors. Three of the Barclays offerings are geared to Lehman Brothers Treasury bond indexes (1-3 year, 7-10 year, and 20 year) while the fourth is based on the Goldman Sachs InvesTop corporate bond index.

While the bear market has been prevailing for more than two years, investors have run out of patience with equity funds and lost confidence in stock picking. The advent of bond ETFs seems to provide investors that are in love with conservative asset classes with a broader choice of product structures. The new BGI offerings carry rock-bottom expense ratios of 15 basis points (0.15%), which are low enough to balance out brokerage commissions over the long haul.

More ETFs on the Way

New York-based ETF Advisors, led by ETF guru Gary Gastineau, recently introduced four bond ETFs dubbed FITRs (pronounced "fighters"), or Fixed Income Trust Receipts. The funds will invest in high-quality government securities based on 1-, 2-, 5-, and 10-year Ryan on-the-run Treasury indexes. They are listed and traded on the American Stock Exchange.

Two firms known for catering to market-timers have registered for leveraged ETFs. ProFunds is planning to launch eight ETFs, among which four bullish funds will try to double the daily performance of respective market indexes whereas four bearish siblings will employ futures, swaps and other financial instruments to double the inverse of their benchmark daily performance. ProFunds archrival Rydex is also preparing leveraged ETFs. The leverage approach magnifies the market movements, so such products can be too risky for ordinary investors.

Having made appearance in Europe, UBS will test the U.S. waters with two equity ETFs under the same Fresco brand, tracking the Dow Jones Stoxx 50 and the Dow Jones Euro Stoxx 50 indexes on the NYSE.

Index giant Vanguard also plans to expand its ETF roster with three international offerings, by adding VIPER shares to its existing European Stock Index Fund, Pacific Stock Index Fund, and Emerging Markets Stock Index Fund. These Vanguard offerings will broaden ETF availability for European and Pacific indexed product, and initiate the first ETF for an emerging markets index.

Actively managed ETFs have already been a center topic for the ETF evolution; however, with many issues, such as portfolio transparency, still to be ironed out, actively managed ETFs will probably not emerge onto the financial services stage in the near future.

NYSE Competing with the AMEX

The NYSE is aggressively expanding its ETF business to compete with the American Stock Exchange, which has dominated the ETF arena since 1993. The Big Board started listing the iShares S&P Global 100 in December 2000. In July 2001 it began trading three most active ETFs on an unlisted trading privileges (UTP) basis.

Besides adding another 33 ETFs this year, the NYSE has developed NYSE-branded indexes with Dow Jones, which will lead to more index-based ETFs. Despite a lot of catch-up, the NYSE will likely acquire some market share due to its name recognition. As a result of heightened competition, ETF players can negotiate better terms with exchanges.

Education, Education, Education

As an investment alternative with about $89 billion in assets, ETFs will not pose an immediate threat to mutual funds, but they should enjoy vigorous growth in the years ahead. With an expanded education effort, ETF sponsors can increase investor awareness of the product, because attributes such as low expenses, high tax efficiency and broad diversification are in strong demand under current market conditions.

Targeting fee-based advisors could be quite fruitful since asset allocation fit and low costs are primary drivers of their purchase decisions. ETFs have so far been the playground for sophisticated investors, but with more education about the use of ETFs, other segments of investors can be conquered as well.

Jing Sun is a research analyst with Financial Research Corporation. FRC is a financial services consulting firm specializing in market analytics and defining future trends in the mutual fund, VA, separate account, hedge fund, ETF and alternative product arenas.