The ongoing, rapid growth of ETFS begs a question: is it sustainable, or will the market soon find itself in a bubble? A new global report on the ETF industry says there is little to stop its momentum.

"There are many large and well-established firms which have significant resources and distribution networks to meet the current and future demand of various institutional and retail investors who are looking to use ETFs as part of their investment strategies," says Bill Donahue, managing director, ETF practice leader with PwC in the U.S.

"We expect ETFs to continue to gain significant flows across U.S., Europe and Asia, with even greater opportunities in less developed ETF markets such as Latin America, the Middle East and Africa."

Donohue and his PwC colleagues explored the growth challenges and opportunities facing the ETF industry in a new research report, "ETF 2020: Preparing for a New Horizon," one of a group of new papers examining the rapid development of the ETF industry in the U.S. and globally in the past year.

Surveying over 60 firms globally, Donohue says PwC identified smart beta as a leader among growing ETF segments. "We see significant opportunities for new types of indexing ETFs, both in the U.S. and Europe," he says. "Active ETFs also have significant runway in both the U.S. and Europe. In the U.S., we also see the potential for significant growth in the active ETF space, both for fully transparent as well as non-transparent active ETFs."

Another factor in the growth of ETFs, Donohue says, is the regulatory approval of Eaton Vance's non-transparent ETMF.

"We expect that there will be continued developments with respect to other types of periodically disclosed active ETFs in the U.S. over the next year or so," he says. "It will be important for any firm launching non-transparent active ETFs to invest a significant amount of time to educate market participants and investors on the key features, benefits and risks of their respective investment products.

"Additionally, there will likely be impacts to systems and processes for exchanges, authorized participants, broker dealers, and other service providers to accommodate the trading and record keeping for these new investment products."

PASSIVE, ACTIVE

Another ETF market report from Broadridge Financial Services sought to portray the growth in figures.

"ETF assets across all channels increased by 17% reaching $2.08 trillion in 2014," says Frank Polefrone, senior vice president of Access Data, a Broadridge company. "Overall fund and ETF assets under management increased by 12% in 2014 and we saw independent broker-dealers and registered investment advisors continue to outpace wirehouses - a trend that we expect to continue in 2015.

Two major reasons, Polefrone says is the increased use of ETFs by advisors and retail investors they service, and the number of firms, including mutual fund companies, that are entering the market and developing both passive and actively managed ETFs.

Broadridge also reported that total third party distribution of long-term mutual fund and ETF assets increased to $9.54 trillion last year. Leading was the IBD channel with $2.33 trillion, RIAs with $1.74 trillion, wirehouses with $1.68 trillion and private banks with $1.49 trillion, the firm reports, adding that IBDs were the leading distribution channel for long-term mutual funds in 2014, increasing $213 billion to a total of $1.95 trillion assets, while the leading distribution channel for ETFs was RIAs, which accounted for $413 billion in assets in 2014.

There was a 19% growth of passive products across third party distribution channels compared to 12% growth of actively managed products, the firm reports. "RIAs have a higher usage of ETFs and index mutual funds, while traditional broker dealers' usage of passive products has not changed to any great degree," Polefrone says.

The passive/actively managed mix among third party distributors, according to Broadridge, increased from 27/73% at the end of 2013 to 29/71% by the end of the 2014.

Still, the active ETF market shared in the industry's overall growth, with the number of available active ETFs growing in 2014 from 73 to 125, while active ETF AUM grew 16.5% to $17.265 billion, according to a new report from active ETF provider AdvisorShares.

"We will likely see the flows in ETFs as a leading indicator of how investors are adjusting their investments," says Noah Hamman, CEO of AdvisorShares. "I also expect to see much more investments across the board in active ETFs as they start to develop longer track records."

KEY CHARACTERISTICS

Reflecting on the products in the ever increasing ETF marketplace - there were 204 ETFs launched in the U.S. alone last year, according to First Bridge Data - Hamman says that the definition of success factors for a product can vary.

"I often read the best ETFs are the largest ETFs, and their assets under management are seen as an indication of success. However that success is just for the ETF sponsor. We believe there are two types of ETFs and each have their own factors that makes it a better ETF.

"If you are an index-based ETF - meaning any kind of index and the portfolio manager's job is to track, not beat an index - then low cost and zero tracking error are the important factors," Hamman notes. "As for which index ETFs perform better will just be a function of the current market cycle. If you are an active ETF, then you need to provide better risk adjusted returns than your comparable index benchmark for a reasonable fee. We all know how difficult that is to accomplish."

For many ETF providers, the challenge is to find the proper product for the right sliver of the market, says Mike McGlone, director of research at ETF Securities U.S.

"The key thing is if your company can fill a niche," he says, noting that it took the company four years before it launched two new index funds with Scientific Beta at the beginning of this year. "Providers are trying to fill in a niche and not have to worry about closing a fund."

In some aspect, the market is beginning to mature, McGlone adds. "Our focus is now on where we can we make some money. It's a different dynamic. AUM is not so important as the revenue that you can generate by products." 

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