This article initially appeared in ETF Report.
We gaze into our crystal ball to serve up a taste of what you can expect in the ETF industry this year ...
Betting on what the market will do is a crime of passion few die-hard indexers are known to commit.
In the peaceful land of passive ETF investing—the one so many of us like to call home—we go through our days avoiding the hype, ignoring CNBC's Jim Cramer, and focusing on what we like to call our long-term asset allocation plan. It's nice, if not downright sensible, to own the market, to ride the ups and downs relatively unscathed by simply ignoring our urge to react.
But the beginning of a new calendar year has a way of inspiring change. As people, we like to make resolutions and imagine that with some diligence we can work up a better future. As investors, we like to read predictions, take control of our investments, and think that maybe this year we'll find that elusive alpha we keep hearing about.
It's in that spirit we offer what we consider to be the top predictions for the ETF market in 2014. Enjoy.
1. ETF STRATEGISTS: BIG GROWTH, BIGGER RISKS
ETF strategists—asset allocation experts that provide model ETF portfolios to other advisors—have become a huge force. From meager numbers just a few years ago, these strategists now manage more than $80 billion, according to Morningstar. That's up 46% from year-ago levels.
We think growth will accelerate in 2014, bringing with it things that are good, mixed and ugly.
There's an unmitigated good to the ETF strategist boom. Being an advisor is hard. Between handling clients, prospecting for new business, gauging referrals and dealing with paperwork, an advisor's job is never done. Asking firms—particularly smaller firms—to also be experts in global portfolio management is a bridge too far for some. ETF strategists offer a solution.
Some ETF strategist firms are truly great. They offer amazing, well-constructed portfolios at low costs. Money will flow to these firms and investors will be better off for it. In many ways, it's the ETF dream fulfilled: institutional-quality port-folios, with institutional-quality products, at institutional-level pricing.
While some ETF strategists build amazing portfolios, we worry about others. Some of the more popular ETF strategists offer portfolios with extraordinarily high turnover (200%+ per year) and extreme aggression levels.
Many firms have built up strong track records, and we're not so jaded as to discount that. But any student of finance knows that at some point, the music will stop. The ETF strategist community hasn't repealed the fundamental law of active management: On average, over the long haul, most actively managed strategies will underperform the market. We expect some strategies to crash and burn as markets continue to evolve.
The old adage applies: Past performance is no guarantee of future returns. In fact, history would suggest the opposite.
We think two big issues will challenge the ETF strategist space in 2014.
First, trading and execution will be a big deal. As strategists move from managing millions to managing billions, trading pressures mount. When billions of dollars are linked to the same model and try to make the same exact trade at the same exact time, investors can get hurt. Strategies will try to cope with this by launching mutual-fund versions of their strategies or partnering with trading firms to guarantee executions. However, before you buy, ask your strategist if they are seeing a gap between model returns and the real returns investors experience.
Second, we expect significantly enhanced regulatory scrutiny of ETF strategists. One firm is already reported to be under investigation by the Securities and Exchange Commission for presenting backtested data as real returns. If you see one, there are probably more out there waiting to be exposed.
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