After years of rapid expansion, exchange-traded funds' growth has slowed as the economy shrinks.
Many exchange-traded funds that tracked more exotic indexes have been closed and unwound, and others languish with few or no trades.
But product providers are fighting back with issues designed for the bear market, such as leveraged and inverse exchange-traded funds offered by ProShares, a unit of ProFunds Group, or, more recently, Direxion Funds, a unit of Rafferty Asset Management LLC. And investors are showing interest in new fixed-income ETF offerings such as prerefunded muni bonds, high-yield muni bonds, high-yield taxable bonds, international bonds and emerging-market bonds.
A significant expansion in ETF bond products has taken place. From mid-2008 until early this year, muni bond ETFs like the iShares S&P National Muni Bond Fund and PowerShares Insured National Muni Bond Fund were popular, but in the current phase of the economic downturn, experts are cautioning investors about the credit risk of municipal and other tax-advantaged issues.
Scott Burns, an ETF analyst at Morningstar Inc., said investors must watch out for muni index ETFs, "particularly the bigger ones, like California or Arizona bonds, where the credit risk is greatest."
He said that these funds are more useful for speculative trading purposes than as anchors in a portfolio.
Cautions also apply to most of the other new exchange-traded funds in the fixed-income category, which until last year was limited to Treasury ETFs, said Greg Maddox, the director of manager research in the private banking and wealth group at Wells Fargo Bank.
The iShares' Barclays Euro Corporate Bond ETF or State Street's SPDR Barclays Capital Mortgage-Backed Bond ETF have credit and interest rate risks that must be clarified for clients. So too with high-yield munis, high-yield taxable bonds and emerging-market bonds.
An exception is prerefunded municipal bonds like the Van Eck Market Vectors Pre-Re Muni Index ETF introduced in February. Pre-re muni bonds are fully backed by Treasury securities that a municipality buys and holds in escrow to cover the coupon payments and the principal at maturity.
Last year, prerefunded munis returned 6.5%, compared with a 2.5% drop in the overall muni market. Market Vectors' Pre-Re Muni ETF showed a market return of 0.45% and an NAV return of 1.15% for March, the issue's first full month on the market.
The bear market also has made investors curious about commodity ETFs and newer leveraged and short commodities ETFs, like the ProFunds leveraged and short gold and silver ETFs started last December.
"Economists say the stimulus program will likely create an inflationary environment," said Morningstar's Burns, "and people want protection against that, hence the interest in commodity ETFs." Gold ETFs have been popular as concern grows about the dollar.
About 24 commodity ETFs traded in 2008, and new ones, like equity ETFs before them, now offer the opportunity to leverage or short commodity indexes.
Inverse ETFs, which let the holder win when the market loses, or even to double or triple a market decline, are attracting interest. "People are using the inverse products to hedge the markets as they go down," said Wells Fargo's Maddox, "but there's a great deal of risk in inverse products. You can't just set 'em and forget 'em." These ETFs are reset every day.
Using a more basic product like ProShares Ultrashort S&P 500, which offers a double-inverse tracking of the S&P 500 Index, will deliver an accurate double inverse of the index's performance, said Michael Sapir, the chief executive officer of ProShares Advisors.
A lot of new hedge products also try to replicate the hedge bets of alternative instruments, said Maddox, "only they are more liquid." Like the first such ETF, the IQ Hedge Multi-Strategy Tracker, introduced in March, these are "very complex," he said, adding that for now Wells prefers the traditional hedge fund structure.
Maddox said that he warns investors to stay away from exchange-traded notes. Though these were popular last year, exchange-traded notes are promissory notes and, thus, a kind of derivative rather than a bundle of actual stocks or bonds.
Some issuers, he said, are having trouble raising capital, "so we recommend avoiding them in the near term."
In general the numbers suggest that, even with investors leery of financial markets, exchange-traded funds are gaining ground, particularly compared to mutual funds.
In 2008, mutual funds lost close to $400 billion of invested assets, in addition to the capital depreciation they suffered in the market crash, according to Tom Lydon, the editor of ETFtrends.com.
During the same period, ETFs had a net inflow of $178 billion, some of it new and some of it shifting away from mutual funds.
The trend is clearly toward more complicated exchange-traded funds.
Lydon, for example, said that he expects to see an increase in actively managed ETFs, with a lot of pressure on them to outperform their benchmarks. He even predicted a period of "personality" ETFs marketed on the active manager's name recognition.