Going forward, there will be more providers, more users, and more penetration by ETFs in the global market for investment products. Money managers will need to decide how to best market and position their firms in this new environment as more investor types adopt ETF and various types of active ETFs become a reality. Whether or not they intend to launch ETFs of their own, everyone needs an ETF strategy.

The year 2013 was another banner year for ETFs, with global assets climbing to a record $2.4 trillion according to ETFGI. With investors fleeing gold funds, net asset flows of $243 billion actually trailed the previous year's $265 billion, but strong market appreciation and robust flows to a variety of equity categories was enough to drive a 23% increase in assets from a year earlier.1 Growth was especially strong in the U.S. market, where $177 billion of net new flows helped boost assets 26% over the previous year to a record $1.7 trillion. Fewer new ETFs were launched in the U.S. during 2013, and four funds shuttered for every 10 introduced. With index products already available in virtually every asset class, more fund sponsors are choosing to rationalize product lines while simultaneously looking for new opportunities.

Is the ETF market maturing? Yes and no. It is certainly crowded, with funds occupying virtually every conceivable asset class. Nevertheless, three developments in 2013 lead us to believe that ETF providers are now poised for another phase of evolutionary growth.

1. New approaches to indexing gain traction. Approximately $46 billion flowed to funds that can be lumped together under the "smart beta" moniker in 2013. The label is unfortunate because it implies these funds all take a similar approach (which they don't) and suggests that the approach is somehow superior to traditional market-cap weighted indexing (the jury is still out). Nevertheless, there is growing demand for ETFs that weight their holdings equally, by P/E ratio, by dividend payout ratios, or other factors. Additionally, many ETF sponsors have obtained exemptive relief from the SEC to launch ETFs using self-managed indexes.

2. Firms positioning themselves to enter the actively managed ETF market. Although the term "ETF" has been virtually synonymous with indexing for two decades, there has always been industry chatter about the potential for actively managed ETFs. Since commencing operations almost six years ago, activity has been muted, with most flows going to a handful of fixed income funds. Recently, there have been a growing number of discussions among fund sponsors, attorneys, and regulators on the topic of non-transparent active ETFs which would allow managers to use their active investment strategies without requiring daily transparency of their underlying investment portfolios. While active ETFs represent less than 1% of total ETF AUM in the U.S. there is plenty of interest based on the exemptive relief filings over the last 18 months.

More important though, is the fact that a growing number of prominent asset management firms are jockeying for position in this nascent product category at precisely the moment that funds flows shifted dramatically from bonds to equities. While it is true that indexing has penetrated equity investing more deeply than fixed income, there is still approximately $7.7 trillion in 5,800 actively managed equity mutual funds available in the U.S. market, compared to only $1.4 trillion in 340 equity index mutual funds and $2.9 trillion in 2,300 actively managed bond mutual funds. There is no reason that these ratios should differ when it comes to ETFs. With some firms already testing the waters and others filing for exemptive relief from the SEC in anticipation of launching active ETFs, 2014 may very well be the year this long-awaited trend hits its stride.

3. The ETF ecosystem expands. ETF sponsors are developing increasingly specialized and innovative products in an effort to expand the market, but it may be growing demand from an increasingly diverse group of investors and advisors that becomes the primary driver of growth during the next phase in the evolution of ETFs. As exceptionally versatile building blocks, ETFs are attractive to investors across a growing number of segments. Institutional investors, for example, have always been big users of ETFs but they are using them differently now. While many institutional managers began using ETFs as transition management tools, they now view ETFs as long-term holdings suitable as core allocation vehicles. Global financial institutions, foundations, university endowments, insurance companies, and even central banks are all driving ETF growth.

When the global market is considered, though, it may be the retail market that offers the most promise. Retail investors in the U.S. have already embraced ETFs and already account for more than half of all assets under management, but upcoming regulatory and policy changes are likely to boost retail use of ETFs in Asia and Europe, where market penetration is far lower compared to the U.S. Demand from institutional and retail investors will be stimulated and facilitated by the growing number of advisors, strategists, consultants, platforms, and technology firms providing ETF education and tools for effectively integrating ETFs into their overall portfolio strategies.

Nigel Brashaw is a partner in PwC's asset management practice. A version of this article appeared on PwC’s Asset Management Blog.

 

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