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Originally published in the April 11th 2009 edition of the Financial Post section of the National Post.

Activity in the Exchange Traded Fund (ETF) market has continued to grow during the past year despite difficult market conditions. Activity has been driven by greater institutional and individual investor acceptance and by the introduction of innovative products. Growth has not occurred without controversy.

A good example of growth in the past year is the experience by Barclays Global Investors Canada. For the first time ever, Canadians invested more dollars in iShares ETFs in 2008 than in all Canadian mutual fund providers. Canadians invested $4.4 billion into iShares ETFs in 2008. In addition, trading in iShares ETFs represented 5.3% of all equity trading on the TSX in 2008.

Ironically, Barclays’ trading success in Canada was surpassed by another ETF sponsor. Percent of TSX equity trading in ETFs in 2008 was surpassed by Horizon Beta Pro.

Investors are attracted to Exchange Traded Funds for a variety of reasons. Individual investors like them because they are:

• Easy to understand and follow. Most ETFs track well known indices and sub-indices.
• A convenient way to build a diversified portfolio
• Low management expense cost relative to most actively managed funds
• More tax efficient than most actively managed funds
• Easily bought and sold on equity exchanges
• Better performers than most actively managed funds

Institutional investors like them because they are:

• Easily bought and sold. SPDRs, an ETF tracking the S&P 500 Index are the most actively traded securities in the world.
• Readily used by hedge funds that use long/short strategies. Approximately 20% of ETFs in North America are held as short positions.

The growth in Exchange Traded Funds in the world has been exponential. Exchange Traded Funds first traded in Canada. The first ETF in the world was Toronto Index Participation Units (TIPs). ETFs were adopted by U.S. equity markets in the 1990 and began to appear in Europe in 2005. ETFs now trade in virtually every major equity market in the world.

Much of the growth in recent years has come from expansion into more investment products. ETFs initially tracked well know equity indices such as the S&P 500 Index, Dow Jones Industrial Average, NASDAQ 100 Index and the TSX 60 Index. Now ETFs are available on equity sector indices, equity style indices, international equity indices, bonds, currencies, commodities and commodity futures. In addition, ETFs are available in leveraged and inverse formats. Until last year, most leveraged ETFs offered a double percentage change against the daily fluctuation in an underlying index. The latest ETFs offer a triple percentage change.

Growth will continue. The greatest source for potential growth is the launch of ETFs on actively managed portfolios. Several have been launched during the past year in the U.S.. Claymore Investments in Canada offers several ETFs that select a diversified portfolio of equities based on four fundamental criteria. The first actively managed ETF in Canada was launched by Horizon BetaPro in January when its AlphaPro product was introduced. Equity selections for this fund are made by Ron Meisels, a technical analyst.

ETFs have become a significant influence on the performance of selected sectors and markets. Some of these influences have raised regulatory concerns. The Gold ETF (Symbol: GLD) backed by gold bullion has grown so large that its fund currently is the third largest holder of gold in the world behind the U.S. government and the International Monetary Fund. The ETF that track crude oil futures in the U.S. (Symbol:USO) has become the largest holder of current month crude oil futures contracts. Rolling over futures contracts from the current month to the next month recently caused significant disruptions in the futures market to a level where the ETF no longer consistently tracks the price of crude oil. The iShares U.S. long term Treasury bond fund (Symbol: TLT) has become so large that it virtually has become the preferred way for investors to participate in the U.S. government bond market. Activity in inverse financial service ETFs in the U.S. rose to record levels recently, but was used by hedge fund managers to overcome temporary rules set by the Securities and Exchange Commission to prohibit short sales of selected U.S. bank stocks. Short sale rules became an important issue again this week. Their potential impact on existing inverse ETFs is unknown.

ETFs based on futures contracts have become controversial in recent months. They deliver expected returns in line with expectations when rebalanced on a daily basis. However, their tracking ability diminishes if they are not rebalanced on a regular basis. Accordingly, they are attractive for traders with a relatively short time horizon (say three weeks or less) who want to take advantage of an index with a defined up or down trend. They are less suitable for longer term investors, particularly when the underlying index is trendless.

Don Vialoux, Chartered Market Technician is the author of a free daily report on equity markets, sectors, commodities, equities and Exchange Traded Funds. Reports are available at www.timingthemarket.ca . Mr. Vialoux does not own Exchange Traded Funds mentioned in this report.