Trends Driving ETF Product Development

November 21, 2018

[This article appears in our December 2018 issue of ETF Report.]

 

The ETF factory is humming along, delivering 228 new ETFs in 2018 (as of the end of October), and taking an impressive 145 or so strategies off the shelves. This is a 25-year-old marketplace that’s clearly maturing, but not yet done innovating.

At a quick glance, the new launches touched just about every market segment, offering investors new and novel access and exposure choices within asset classes. The pace of launches this year remained healthy, and close to that of  previous record-breaking years. Some say nearly 2,200 U.S.-listed ETFs is too many; others say there’s always room for new and improved mousetraps (Figure 1).

 

 

The closures—with the exception of five ETFs—were all funds that had far less than $100 million in total assets. These unwanted and unloved few were surprisingly high in number this year. By early November, they had already outpaced 2017’s 138 total closures.

The list is definitely going to be longer than usual for 2018 in its entirety. Don’t forget that number got boosted in part by the shutdown of 50 iPath ETNs back in April. There were even a handful of funds that opened and closed within the first 10 months of 2018. That’s happened before, but it’s rare.

Perhaps one takeaway from the annual cycle of launches and closures is that the ETF market is doing a good job of regularly cleaning house. Issuers have shown they’re willing to accept that not all ETFs are viable, and know that getting rid of dead weight is just as important as bringing new strategies to market. 

Trend 1: Active Management
There are other trends driving ETF product development in 2018. No. 1 on that list is the impressive expansion of active management. The mostly passive world of ETFs welcomed an unusually high number of active strategies this year—59 in all by Nov. 1.

That means roughly 25% of all launches this year were actively managed funds, a meaningful number given that, today, there are only 251 active ETFs on the market, representing only about 11% of all U.S.-listed ETFs. It’s even more meaningful if you consider that, together, these active ETFs command just over $67.5 billion in total assets, or only about 2% of all U.S.-listed ETF assets.

As a broad category, active management hasn’t been all that popular in the ETF space, yet it’s snagged a lot of the launches this year.

“There is a huge opportunity and a huge white space in the active category,” Bloomberg Intelligence Senior ETF Analyst Eric Balchunas said. “Now, it’s a very challenging space, but it’s still pretty much an open frontier.”

That opportunity is particularly evident on the equity side, where traction has been hard to come by. Of the 15 largest active ETFs today, boasting at least $1 billion in total assets, only two are equity funds—the $2.1 billion First Trust North American Energy Infrastructure Fund (EMLP) and the $1.3 billion ARK Innovation ETF (ARKK).

And yet, of all 59 active ETF launches this year, quite a few were nonleveraged U.S. and/or international equity strategies—funds like EquBot’s AI Powered International Equity ETF (AIIQ), the Amplify Advanced Battery Metals and Materials ETF (BATT) and the Opus Small Cap Value Plus ETF (OSCV), to name a few.

One launch was particularly fascinating. In March, BlackRock's iShares rolled out a family of actively managed nontraditional sector funds under the "Evolved" name. The funds implement machine learning algorithms to identify companies falling within their sectors.

Another notable entrant in this space was Vanguard, with the launch of six active factor ETFs, offering access to value, momentum, minimum volatility, quality, liquidity and a multifactor portfolio. They include the Vanguard U.S. Liquidity Factor ETF (VFLQ), the Vanguard U.S. Minimum Volatility ETF (VFMV), the Vanguard U.S. Quality Factor ETF (VFQY), the Vanguard U.S. Value Factor ETF (VFVA), the Vanguard U.S. Momentum Factor ETF (VFMO) and the Vanguard U.S. Multifactor ETF (VFMF).

To many, Vanguard’s launch marked an important milestone for actively managed ETFs given the company’s well-known affinity for low-cost passive investing. If Vanguard can go active, anyone can. 

Trend 2: Smart Beta 
The Vanguard lineup of factor funds also brings us to the No. 2 biggest trend in ETF product development this year: the still-strong proliferation of smart beta.

Several funds that launched this year employ nonmarket-cap-weighted strategies, including multifactor, fundamental and equal-weighting schemes across asset classes (Figure 2). 

 

 

Vanguard’s active factor lineup itself is an interesting example of active and smart-beta trends in one. These six funds are actively managed, but they also rely on rules-based, quantitative models that look into various metrics of each specific factor for security selection, and employ a proprietary weighting scheme.

Smart beta has also been proliferating in the fixed-income market. Several bond ETFs that launched this year use fundamental or multifactor selection and weighting methodologies—as opposed to the more traditional market-value-weighted portfolios—offering investors targeted access to fixed income.

For example, the FlexShares High Yield Value-Scored Bond Index Fund (HYGV), which launched in July, is an optimized portfolio that relies on quantitative factors in an effort to capture value and ensure liquidity. It’s a smart-beta bond ETF that uses a fundamental selection and weighting scheme.

Another example of this burgeoning space is the Invesco Multi-Factor Core Fixed Income ETF (IMFC), which is a multifactor ETF. IMFC taps into five fixed-income strategies at once, screening for things like maturity, credit, quality and value factors. The ETF is also cheap for a smart-beta fund, costing 0.12% in expense ratio, or $12 per $10,000 invested.

These launches, as Nasdaq Head of ETF Listings Steve Oh put it, show “there’s been a continuation of trends that started a few years ago and continue to get traction such as fixed-income issuance and smart beta.”

“You’re not seeing a lot of competitors in the traditional market-cap space coming into the market to challenge the likes of Vanguard, BlackRock, State Street and Schwab, because it has to be a very low-cost proposition,” Oh said. “We’re seeing more issuers trying to capture new themes and look for a better mousetrap in 2018.”

Trend 3: Bring Your Own Assets
One of the most interesting trends in product launches in 2018 is the new wave of what Bloomberg’s Eric Balchunas has labeled “bring your own assets.” These are ETFs that come to market and very quickly grow thanks to client assets coming from the issuer itself.

Showing the market how this is done better than anyone else this year was J.P. Morgan. The firm launched a family of funds known as BetaBuilders, strategies meant to be core beta portfolio holdings for a cheap price.

These BetaBuilder ETFs, only a few months old now, are in some cases already multibillion-dollar funds thanks in great part to J.P. Morgan client assets that, prior to these ETFs, sat in competing funds from issuers like iShares.

Among these blockbuster launches are funds like the JPMorgan BetaBuilders Japan ETF (BBJP), costing only 0.19% in expense ratio, and already boasting $2.5 billion in total assets only five months after inception.

The JPMorgan BetaBuilders Canada ETF (BBCA) is a $2.2 billion fund that’s barely three months old, and the JPMorgan BetaBuilders Europe ETF (BBEU) already has $1.3 billion in assets. These are just some of the firm’s BetaBuilder lineup.

“What J.P. Morgan did this year is put in-housing on the map,” Balchunas said. “J.P. Morgan has four (launches) in the top 10. Talk about rookie of the year.” (See Figure 3.)

 

 

The relevance of this somewhat-novel—and still nascent—trend in the ETF space is that it could, over time, challenge the well-established world order of the who’s-who in this industry.

As Balchunas so aptly put it: “One of the only things that could possibly slow down BlackRock and Vanguard in their rise to world domination is more, big in-housing moves”; in other words, big asset management firms launching their own versions of “cheap core Acme brand” ETFs and investing their own clients’ money into them.

Wannabe Trends
On a side note, two areas of the market that started out with all the hallmarks of being hot trends this year just didn’t quite deliver. 

The first and most obvious one is cryptocurrency ETFs. We talked plenty about them in 2018. But after rounds of filings, public comments, regulator concerns and refusals, and more public comments, it looks like 2018 won’t be the year the market welcomes its first bitcoin ETF—at least as of the time of this writing—though there were several launches targeting the blockchain technology underlying cryptocurrencies.

The second “would-be trend that wasn’t” is ESG investing. There were 11 ESG ETF launches in 2018, many of them presenting unique angles on the space. As Laura Morrison, global head of listings at Cboe Global Markets, put it, we “thought there would be more.” 

It hasn’t been for lack of ink spilled on what environmental/social/governance-based investing is, or its benefits beyond feel-good investing. It also isn’t due to lack of ETF offerings, even though the space is still growing. 

But as a segment, ESG ETFs have yet to take off. It could be that investors and advisors still suffer from fear of missing out when it comes to ESG investing. Some view ESG screens as gatekeepers that may omit from a portfolio some securities that would deliver solid returns.

That type of concern, coupled with the fact that there’s no single recipe for ESG investing—each strategy evaluates ESG metrics differently—contributes to slow adoption. That said, new ETFs such as the iShares ESG U.S. Aggregate Bond ETF (EAGG), launched in October, aren’t all off to a slow start. EAGG already has nearly $55 million in assets.

ESG ETFs may not be prime time yet, but they aren’t going anywhere. Chances are they’ll make their mark as the “top ETF trend of the year” soon enough.

 

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