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.”

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