[This article appears in our December 2016 issue of ETF Report.]

2016 has been a wild ride for the markets, but assets have flowed into ETFs nonetheless. As the still-young industry has evolved, every year brings major changes and surprises. At ETF Report, we have a front-seat spectator’s view on the ever-changing shape of the ETF space, so what follows is a rundown of our key expectations for the coming year.

From the asset classes we expect to thrive or flounder, to the trends and strategies that we see coming to the forefront, these are our best-educated guesses for what the new year will bring, along with the evidence and data upon which we’ve based those predictions.

FURTHER BLURRING OF LINE BETWEEN ACTIVE & PASSIVE

Actively managed ETFs have yet to gather any significant traction. Of the nearly 2,000 ETFs listed in the U.S. today, less than 10% are actively managed. Combined, they represent less than 1% of total assets under management.

These are small numbers. And 2017 isn’t going to be the year when the tide finally turns for these strategies.

Instead, what we see happening next year is the further blurring of lines between active and passive, with ETFs coming to market that try to combine the best of both worlds into one single wrapper.  

Cases In Point
Consider the Elkhorn Fundamental Commodity Strategy ETF (RCOM) as a great example of this trend. Just launched in September, RCOM is officially listed as an actively managed ETF. But at heart the fund is an index-tracking strategy that has an active element to it.

RCOM tracks the Dow Jones RAFI Commodity Index, which is a broad commodity benchmark, but it seeks to capture added returns by actively managing on the side by investing the fund’s collateral in things like U.S. government debt, corporate bonds and money market instruments. In the end, RCOM is labeled an active ETF, but it will be the passive commodity index that will likely dominate its returns.

Another example? The WisdomTree Managed Futures Strategy Fund (WDTI). The ETF is actively managed, but its prospectus specifically states its objective: “The fund is managed using a quantitative, rules-based strategy designed to provide returns that correspond to the performance of the WisdomTree Managed Futures Index—the ‘Benchmark.’” WDTI is an active ETF that’s looking to match a benchmark.

There’s also the interesting case of the Cambria Shareholder Yield ETF (SYLD) and its counterpart, the Cambria Foreign Shareholder Yield ETF (FYLD).

SYLD is an actively managed ETF that picks and weights stocks based on a company’s cash flows. FYLD, meanwhile, strives to offer similar exposure in developed-market non-U.S. equity, but it does so by tracking an index of 100 equally weighted stocks.

It could be argued that SYLD might be active in name only because of its particular exemptive relief rules. Both ETFs follow similar rules-based methods from the same issuer, but they are each applied to U.S. and foreign markets, respectively. In other words, SYLD and FYLD differ due to happenstance of their exemptive relief based on their geographies. Essentially, they are only active and passive, respectively, because of a difference in rules.

The Smart-Beta Element
And these are just a few examples. Elsewhere in the ETF space, this blurring of lines is also seen under the increasingly broad umbrella of smart-beta funds.

Some passive smart-beta ETFs take a lot of active risk—think single-factor funds with few portfolio constraints that stray significantly from marketlike exposure, for example.

They may be passive in name, but they’re more like active ETFs than you might think.

At the end of the day, we’re talking about an ETF market that no longer can be split solely into two—passive versus active.

“The blurring of lines means there’s a continuum of passive to active exposure and risk beyond binary labeling of active and passive,” said Paul Britt, ETF analyst with FactSet.

Going forward, we’ll continue to see new ETFs challenge this long-standing labeling practice. 

COMMODITIES FACE AN UPHILL BATTLE

It’s hard not to look at the gains commodities have made over the past year and utter a sigh of relief.

After a disastrous 2014 and 2015, commodity indexes notched respectable increases this year. As of Oct. 21, the broad-based S&P GSCI Total Return Index was up 7.77% year-to-date. The Bloomberg Commodity Index, meanwhile, rose 9.61%.

Don’t be fooled, however. 2016 wasn’t a rally so much as a rebound—and a modest one at that. Broad-market indexes remain double-digit percentages below the levels struck in the heyday of the commodity boom, when it seemed like nothing could stop the surge in prices.

“It’s really been one of the most remarkable periods of underperformance,” said Rob Lutts, president and chief investment officer of Salem, Massachusetts-based Cabot Wealth Management. “Name the commodity—oil, copper, sugar, corn—it’s been a bear market all over the place.”

We believe commodity markets still face significant head winds in 2017, including:

1) Lower Chinese Demand
Demand from emerging markets, especially China, stoked the fire under the late-2000s commodities boom. But Chinese appetite for raw materials has eased, as the country shifts from a manufacturing economy to a service-driven one. That deceleration in demand from the world’s second-largest economy will likely continue to limit commodity prices.  

2) Broad Oversupply
From corn to copper, many commodities now stagger under significant supply gluts. China has made a concerted effort to stockpile base metals, for example, while U.S. farmers are reaping record corn and soybeans harvests, on top of massive existing supplies.

Then, of course, there’s oil. Significant stockpiles have amassed, fed by U.S. shale oil and other low-cost production sources. That’s pushed prices down from more than $100 a barrel in 2014 to roughly $50 today. 

Some producers have discussed throttling supply; in September, OPEC even cut its production for the first time in eight years. However, it’ll take time for such cutbacks to make a dent in supply—if they even can. 

3) Stronger Dollar  
Right now, the U.S. dollar is stronger than it’s been in more than a decade. As a result, commodities priced in dollars—as most are—become more expensive in other currencies, crimping demand. 

A strong dollar is especially bad news for gold, which has an inverse relationship with the greenback. (Whither gold goes, so do other precious metals, like silver and platinum.) That means, if the dollar remains mighty, gold’s future will likely be hamstrung.

That said, there’s still some hope for commodities, as producers slash output and table new projects. Plus, we’re just one bad-weather event away from erasing agricultural stockpiles entirely.

“Try to find someone who’s really bullish about commodities today. It’s not easy,” noted Lutts. “But everything goes through cycles. Will we ever see again a cycle as dramatic as the 2007-2008 boom? Probably not. But commodities may have intrinsic value now that’s higher than current prices.”

END OF EARNINGS DECLINE IS NIGH

Earnings for the S&P 500 have registered five-straight quarters of year-over-year earnings declines through the second quarter of 2016. In that time frame, the index has largely been range-bound and flat, unable to break decisively above the 2,100 level.

That’s no coincidence. For stock prices, the No. 1 driver is earnings. When earnings aren’t rising, it’s difficult for stocks to climb.

Fortunately for bulls, the factors that drove the current “earnings recession” are coming to an end. That may finally drive earnings higher, pushing up the S&P 500 and ETFs tied to the venerable index, including the SPDR S&P 500 ETF (SPY), the Vanguard S&P 500 Index Fund (VOO) and the iShares Core S&P 500 ETF (IVV).

Oil & The US Dollar
Plunging oil prices (which depressed earnings for energy sector stocks) and a surging U.S. dollar (which weighed on profits for multinationals) were the two largest contributors to the earnings recession.

However, these factors will soon cease to be a drag on earnings growth. Oil has doubled off its worst levels of the year, and the dollar, while still elevated, isn’t surging like it was in 2014 and 2015.

In fact, year-over-year earnings growth may have already ticked up into positive territory. As of this writing, corporations are in the midst of reporting their third-quarter earnings. Depending on who you ask, aggregate Q3 profits for the S&P 500 could turn out to be higher than they were a year ago.

Declines Already May Be Over
FactSet is currently estimating a 0.3% decline, while Thomson Reuters estimates a 1% gain. As corporations tend to beat analyst expectations, it’s likely Q3 earnings will end up being marginally higher than they were a year ago, marking the official end of the earnings recession.

More importantly, most analysts see earnings accelerating in Q4, with year-over-year growth of more than 5%. Then in the full-year 2017, if the current optimistic estimates are to be believed, earnings may grow another 10% or more.

To be sure, analysts tend to be overly optimistic about earnings heading into a new year. But the bounce-back in oil prices and a modest improvement in profit margins may be enough to fuel the first notable jump in earnings in years.

The last time S&P 500 earnings increased by double digits was in 2011. If that happens in 2017, the market could surge, pushing the S&P 500 to 2,400 or more.

2017 IS THE YEAR ESG EXPLODES

Environmental, social and governance, or “ESG,” investing is a broad term covering a range of themes, from low-carbon emissions to gender diversity. Essentially, it’s investing with a conscience.

Long dismissed as the singular fancy of granola-crunching hippies, ESG has recently amassed mainstream appeal. As of 2014 (the latest date for which data was available), assets in ESG investments had totaled $6.57 trillion, a 76% increase since 2012, according to USSIF, the Forum for Sustainable and Responsible Investment. 

When it comes to ESG ETFs, however, there’s still plenty of room to grow.

Only 23 ETFs qualify as “socially responsible” (or “principles based”), according to ETF.com. (This doesn’t include environmentally friendly ETFs, which often fall under different classifications.) Eleven—or almost half—only came to market in 2016.

Together, these 23 funds make up just $1.93 billion in assets—a miniscule amount, compared with the $2 trillion invested in comparable mutual funds.

“It’s a small speck in a giant ocean,” said Greg Lessard, founder of Aspen Leaf Partners, a Golden, Colorado-based advisory firm that invests solely in ESG products. “ESG is still a niche market, but the potential is there to grow, and grow quickly.” 

Tipping Point

We believe 2017 will be a tipping point for ESG ETFs, for two reasons.

The first: enthusiasm. A recent survey by U.S. Trust found that interest in so-called impact investing (yet another term for ESG) was on the rise among high net worth women, millennials, Gen Xers and investors with at least $10 million in assets. All demographics roughly doubled their ownership of ESG investments in 2016—with the exception of the $10 million+ investors, who tripled it.

Growth will also likely be driven by pension funds, banks and other large institutional investors, who’ve gravitated in recent years toward companies that are more environmentally friendly and that have better governance. 

The second reason we think ESG ETFs will hit critical mass in 2017? Performance. When you crunch the numbers, ESG actually seems to work better than vanilla indexing.

For example, over a three-year period, the MSCI EAFE ESG Index outperformed the MSCI EAFE Index by more than 120 basis points, according to analysis by FactSet.

As issuers realize this potential boost, we’ll likely see more products launched—even smart-beta twists, such as the offerings by Oppenheimer Funds, who filed for two revenue-weighted ESG ETFs in August. 

ESG ETFs do face a big head wind, however: fees. Though newer funds are cheaper, the average expense ratio in the space is 0.49%. The AdvisorShares Global Echo ETF (GIVE) charges a whopping 1.50%. It remains to be seen whether competitive pressure will push expenses down.

SMART-BETA ETFs POISED FOR INSTITUTIONAL GROWTH

The impact costs have on investment returns is finally sinking in, and smart-beta ETFs will allow institutional investors the better performance promised by active management, but at a cheaper price point.

With low investment returns forecast for the next several years and institutions’ need to outperform the Standard & Poor’s 500 Index, these investors are reviewing their options.

Cheaper & Tax Efficient
Compared to active managers, smart-beta ETFs offer the same outperformance opportunities, but do it inexpensively and with better tax efficiency, says Eric Balchunas, ETF analyst at Bloomberg and author of the book, “The Institutional ETF Toolbox.”

Smart-beta ETFs “use an active manager’s secret sauce and turn it into a rules-based index. That truly is the replacement for the active manager,” he said.

Beyond costs, smart-beta ETFs offer institutions flexibility they haven’t had before. Balchunas says institutional investors find comfort in the fact that most ETFs are approved by the Securities and Exchange Commission under the 1940 Investment Act, plus ETFs offer liquidity and anonymity they didn’t have before. ETFs can also be lent out, which lets institutions take in some money and cover the expense ratio.

“ETFs bring [institutions] freedom and liquidity. They don’t have to call somebody if they want to get out of [their position], somebody who might try to talk them out of it,” he said.

And the room for growth is evident in the accompanying table showing the breakdown of institutional usage when it comes to ETFs. Institutions have just scratched the surface.

Pensions Turning To ETFs
Balchunas says several types of institutions could benefit from using smart-beta ETFs. Pensions are already starting to replace pricey hedge funds with smart-beta ETFs.

“Hedge funds make up a disproportional amount of the cost. Pensions are underfunded, and one way to help get more of the market return is to go low cost,” he added.

Endowments are another area for smart-beta ETF use. For the past few years, endowments tried to match Yale’s returns, but interest in that model seems to be waning, notes Balchunas.

“If you use smart beta right, it can be just as powerful in terms of creating alpha as picking hedge funds or using private equity,” he said.

The insurance industry also offers “huge potential,” Balchunas notes. Insurance companies have a fairly small amount of exposure to ETFs, in part because of previous rules set by the National Association of Insurance Commissioners, the U.S. insurance standard-setting and regulatory support organization, regarding ETF use, Balchunas says. With those rules lifted, and more ETFs covering fixed income—smart beta or otherwise—insurance companies are now offered substantial potential for more investment.

Balchunas says the beauty of smart-beta ETFs, unlike passive ETFs, is they can be fine-tuned to overweight or underweight factors like momentum or volatility to get a chance to outperform the larger market.

BOND ETF GROWTH WILL OUTPACE STOCK ETFs

We’re cheating a little here, because this prediction’s already come true. One only need look at net inflows into fixed-income funds in 2016 so far to see that bond ETFs are growing faster than their equity cousins.

As of the end of September 2016, investors had already poured $77.7 billion into U.S. and international bond ETFs, bringing total assets invested in the space to $393.2 billion.

That well outpaces net inflows into stock ETFs over the same period ($52.8 billion). It even swamps flows into fixed-income ETFs for the entire year prior ($61.1 billion).

Sure, bond funds still only represent 18% of the total ETF market. That’s nothing compared to equity ETF assets, which topped $1.62 trillion as of September’s end.

But investors are flocking to bond ETFs in record numbers.

2 Reasons For This Growth
We think that’ll continue for two reasons. First and foremost is investors’ simple, driving need for income—which has been hard to come by in the current environment.

Loose monetary policies by central banks worldwide have depressed yields to super-low, even negative levels. That leaves institutions and other investors hunting whatever income they can find, wherever they can find it.

Investors have been particularly drawn to corporate debt: As of Sept. 30, the $33.2 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) was the fourth-fastest-growing ETF, with $7.19 billion in new flows year-to-date.

In addition, tougher regulations on financial institutions have squeezed liquidity in the secondary market, depleting inventories and spiking both costs and volatility.

In this, bond ETFs offer several advantages. The ETF wrapper makes it easy to purchase diverse bond types in quantity, or from more illiquid sectors, such as emerging market debt. In fact, ETFs are sometimes even more liquid than the sectors they cover, allowing investors to stay nimble in challenging markets. Plus, ETFs are often cheaper than active managers or mutual funds.

ETF Core Investing Tool
“Fixed-income ETFs are becoming an institutionalized part of the investment process,” said Josh Penzner, managing director at BlackRock and head of iShares’ Fixed Income and Insurance Distribution. “In the past, the ETF was just a side note. But now it’s become core to how institutions manage their money.”

To an extent, market conditions favoring bond ETFs will likely persist into 2017. Most central banks are no closer to tightening their monetary policy—meaning rock-bottom yields will probably stick around for some time to come.

Rising U.S. interest rates, however, could dampen enthusiasm for bonds, specifically Treasury ETFs. The Fed has already hiked rates once, and has made noise about raising them again soon.

“There’s no getting around the math,” said Dave Nadig, director of ETFs at FactSet. “Higher rates are bad for bond prices.”

Still, if rates do rise, investors likely won’t abandon fixed income altogether, but rather push into fund flavors that can weather the change, such as interest-rate-hedged funds or floating-rate ETFs. They may also transition into shorter-duration ETFs, or into muni bonds or mortgage-backed securities.

“A significant bond market correction could create buying opportunities for yield-hungry investors who’ve been dabbling in everything from MLPs to smart-beta dividend strategies,” added Nadig.

NEGATIVE INTEREST RATES WILL KEEP GOLD SHINING

If there were ever any doubt about how important gold ETFs have become to the overall gold market, the events of 2016 emphatically put an end to that. During the first half of the year, more than $14 billion flowed into the two largest gold ETFs, the SPDR Gold Trust (GLD) and the iShares Gold Trust (IAU), fueling a 20% increase in gold prices.

The ETF flows were unprecedented, and combined with purchases of gold bars and coins, investment became the largest component of gold demand for the first time. Suddenly, it was investors that were dictating gold prices, overshadowing the usually influential consumer demand for jewelry and purchases by central banks.

There are many reasons gold found favor among investors. Stock market volatility, extreme currency movements, and concerns about the economies of China and Europe were a few.

But most notable was the new paradigm of negative interest rates.

$13 Trillion In Negative Yields
Never before have interest rates around the world been lower than they were in 2016, and never before have negative interest rates been so pervasive. At one point this year, more than $13 trillion worth of bonds were trading with negative yields.

Most of those bonds traded in Europe and Japan, but even in the U.S., yields for 10- and 30-year Treasurys hit record lows in July, pushed down by the unexpected “Brexit” vote in the U.K.

Though yields have since climbed from their lows, they remain at levels once thought unimaginable. Demographics, easy monetary policies and shaky economic growth may keep bond yields capped, even as the Fed gets set to potentially hike its benchmark overnight rate by 0.25% in December.

A continuation of the low-interest-rate paradigm means money should continue to flow into gold ETFs as investors look for alternative safe havens to government bonds (low rates reduce the opportunity cost of holding zero-yielding gold).

Though gold ETFs are unlikely to see inflows anywhere close to what they saw during the first half of 2016, investor demand is likely to remain strong. Another $5 billion to $10 billion of inflows in 2017 wouldn’t be surprising. That, along with a rebound in depressed jewelry demand, may be enough to push gold prices back above the $1,300 mark and beyond in the coming year.

CLOSURES WILL REMAIN AT OR NEAR RECORD LEVELS

Last year was a record year for launches—the most the U.S. ETF industry has seen since 2011. However, 2016 isn’t even over yet, and although it’s seen a respectable number of new ETFs hit the market, it has blown past the previous record for closures.

As of the end of October, with two months left to the year, there were 111 closures, and in prior years there’ve only been two years where closures topped 100. Consider also that November and December often see large numbers of closures.

“A lot of companies try to square up their books at the end of the year and do some window dressing,” said Ron Rowland, founder and executive editor of ETF investing website and newsletter Invest With An Edge, and a portfolio manager with Flexible Plan Investments.

444 ETFs On ‘Deathwatch’
Rowlands maintains the “ETF Deathwatch” list on his website, which generally focuses on ETFs with less than $25 million in assets under management. As October drew to a close, there were 444 exchange-traded products on the list after two consecutive months of falling membership in the club no issuer wants their products to be in.

Although some of those removals were due to funds gathering more assets, even more were due to their closures being finalized.

However, Rowland notes that this year’s been different, with multiple funds with assets above $25 million closing.

“Larger and larger funds are closing. For my deathwatch, I’ve had $25 million as a cutoff, but there’s been many closures exceeding that this year,” he said. Most notable, and perhaps inexplicable, was the shutdown of the SPDR Nuveen Barclays California Municipal Bond ETF (CXA), which had roughly $150 million in assets under management.

And when iShares announced the closure of 10 ETFs earlier this year, half of the list was funds with assets of more than $25 million.

Fee Pressure Raising Breakeven Point
One possible reason is a potential shift in the dynamics of the ETF space at the far end of the spectrum. In a mature industry, established issuers with deep resources and multiple multibillion-dollar funds may simply no longer see such funds as worth their time if they don’t fit the firm’s vision going forward.

Rowland believes it may be that the downward pressure on fees has in turn raised the breakeven threshold for the average fund’s AUM.

That, along with the high launch rate, suggests that the closure rate will remain at or near record levels for the foreseeable future.

“There’s a lag. I’ve noticed that the closure activity tends to lag launch activity—peaks and troughs—by one to two years. There’s definitely what I’d consider a saturation of products, and that’s a contributing factor,” Rowland said. “I think if the launch rate stays high, the closure rate will stay high as well.”

THEMATIC ETFs TO PROLIFERATE IN 2017

Expect to see more novelty investment ideas in 2017 as the flurry of new thematic exchange-traded funds is likely to continue as ETF providers seek to stand out in a bevy of product launches.

Thematic ETFs are narrowly based vehicles that group investments based on a central idea. One of the best-known and biggest thematic ETFs is the PureFunds ISE Cyber Security ETF (HACK), which has $748 million in assets under management (AUM). Another thematic ETF that has gained traction is State Street Global’s SPDR SSGA Gender Diversity Index (SHE), which invests in companies that have women in leadership positions. SHE launched in March 2016 and already has $273 million in AUM.

Ben Johnson, director of global ETF research at Morningstar, agrees that 2017 will see more of these types of ETFs.

“Absolutely. We’ll continue to see proliferation of thematic ETFs,” he said.

But that doesn’t mean investors will bite.

“I would also be so bold as to predict that the vast majority of investors will not take notice. These will be fun to joke about around the water cooler, but you’ll see very few serious investment dollars put into these funds,” he added.

A big part of that reason is that some of these funds are too narrow, Johnson says. That goes against the countervailing trend of what investors seem to want, which is very diversified, very-low-cost, very tax-efficient, very liquid ETFs.

Broad Diversification

“[Thematic ETFs] really don’t have any broad-based use case for a broad spectrum of investors, who more often than not are really trying to diversify as broadly as possible, keep costs as low as possible, and moving ever further away from trying to pick individual stocks or individual themes or time markets,” he said.

For every HACK and SHE, other thematic ETFs have quickly made their way to the graveyard, such as the CrowdInvest Wisdom ETF (WIZE). It rebalanced monthly based on users voting on what stocks to include in the index, but only lasted five months.

Thematic ETFs are a novelty at this point, Johnson says. Launching any new ETFs to fill an outstanding need is tough now.

“The marginal utility of your average newly launched ETF is awfully low at this point,” he noted.

Given the record number of ETFs that have been launched in the past few years, it’s hard for ETF providers to stand out in a crowd, which makes launching these thematic ETFs a way to get noticed.

“We’re years beyond the S&P 500, the Total US Stock Index, the Total US Bond Index and the more meaningful, more useful segments of each of the above,” Johnson said. “But there’s so little white space that it’s only natural that enterprising firms trying to make a name for themselves in this space are forced to hit a button on a random idea generator and put whatever comes out of that machine into an ETF and list it on the NYSE.”

ETF FEE WARS CHANGING SHAPE

In October, we witnessed the latest skirmish in the ETF fee wars as iShares abruptly announced that it had cut fees on 15 of the ETFs in its “Core” family by 2-5 basis points. The move was a swipe at Vanguard, Charles Schwab and even State Street Global Advisors, as it lowered the price on the iShares S&P 500 ETF (IVV) by 3 basis points to 0.04%, nearly half the cost of the SPDR S&P 500 ETF (SPY).

However, just days later, Schwab responded to the volley of price cuts with its own, cutting the expense ratio on five of its key ETFs by 1 basis point each, reclaiming the No. 1 low-cost spot for at least those ETFs’ respective asset classes.

Now that fees on key asset classes are well into the single digits, this raises the question of how much lower costs can actually go. There are actually three ETFs with expense ratios of 0.03%, two from Schwab and one from iShares. Where do you go from there?

‘I Don’t Think We Go To Zero’
Dave Nadig, managing director of exchange-traded funds at FactSet Research, doesn’t think things are going to get too crazy.

“I think there’s a point of diminishing returns.  I don’t think we go to zero, where the investment management is free and the issuers live off SEC lending revenue,” he said.

Really though, the fee cuts are sort of cosmetic on the core funds at this point because, as Nadig puts it, nobody is making money on those products. The purpose of such low fees for the Schwabs, Vanguard and iShares of the world is just to knock down sales barriers, Nadig says.

Goldman Sachs certainly did something similar in 2015 when it launched the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC). The fund costs just 0.09%, the same as SPY, despite being a smart-beta fund. It was considered a shrewd move that garnered a lot of attention, not least because it was a way to draw investors into Goldman’s entire family of smart-beta ETFs. 

5-40 Basis Point Range
Nadig thinks the fee compression will continue in the ETF space, but in a very different way.

“What I think we see is funds pressed into a narrow range of 5-40 basis points, where products over that range really have to fight to prove they’re worth it,” he said.

No longer will it be a battle of core asset classes, but of funds representing subsets of those asset classes or the strategies that target them. Currently, there are more than 1,300 ETFs with expense ratios of 0.40% or more; that means the battlefield is slowly shifting to a much broader field.

“The real fee war will continue up-hill from those lower-cost products. You’ll start seeing products priced at 0.70% getting repriced down into the area of 0.40% and so on,” Nadig said. “I predict a rash of fee compression at the top.”

 

 

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