BBH: ETF Industry Reaching New Maturity Level

Ryan Sullivan
Senior Vice President of ETF Services
Brown Brothers Harriman

Brown Brothers Harriman and ETF.com recently conducted a survey of ETF usage around the world, combining efforts to target investors in the U.S., Europe and Greater China. Here, Ryan Sullivan, senior vice president of ETF services, discusses the findings and what they mean for the overall industry.

What do you see as the most important or exciting takeaways from the study?
What stood out to us most this year were changes in how investors are selecting ETFs. Today lower expense ratios are assumed, and so savvy ETF investors have started to “pop the hood” and look at other key criteria, like historical performance, index methodology, trading spreads and even issuer brand.

We also see a willingness by investors to engage with new products. This year, 40% of respondents said they were comfortable buying an ETF with $25 million or less in assets. That suggests they’re looking more closely at the mechanics of an ETF. And we would argue they’re also trying to get a better sense of the true cost of ownership. Rather than focusing only on expense ratio, they’re looking at trading spread and index methodology to get a more holistic view on what that ETF will cost to hold within a portfolio.

This was the first year the survey went truly global, including the U.S., Europe and Greater China. Did you see any key differences across regions in the responses?
We’ve historically done three separate surveys, one in each region. But this is the first year of bringing all three together into a single review to start tracking some of these nuances in the market.

There are areas where we saw some meaningful distinction. It’s interesting to compare the demand for active and ESG ETFs across regions. Active management is still very much in demand in the U.S. and Europe; it was rated the No. 1 area in which investors want more ETFs available in their local markets. However, it was ranked No. 3 in Greater China, behind core index and smart-beta products. ESG ranked second in the U.S. and Greater China, while it was rated No. 6 in Europe.

This tells us the U.S. and Europe—as it relates to active and smart beta—want more choices in those particular investment strategies, whereas Greater China is looking for products that can serve as core portfolio building blocks. It highlights a contrast between the regions: The maturity and demand for more complex strategies and asset classes is fairly pronounced in the U.S. and Europe versus Greater China, where ETF adoption is just beginning to increase.

In your observation, how have investor attitudes toward smart beta and active management shifted over the years?
This year, we’ve started to see smart beta become an extension of the core portfolio—especially in the U.S. The increase in smart-beta adoption suggests investors understand how they might use those ETFs within a portfolio and are comfortable doing so.

When it comes to hedging against volatility, 38% of investors said they would buy low-volatility smart-beta ETFs. This suggests that investors see some smart-beta strategies as tactical tools, as well as core holdings. And 70% of investors said they hold 6-20% of their portfolio in smart-beta products.

When it comes to active ETFs, we expect to see demand for fixed-income products add to the growing universe of these products. ETFGI reported that we hit another record at the end of January: Active ETF AUM globally stands at just under $112 billion, and we think active ETFs will continue to be a tool used by investors to add alpha and drive enhanced performance in a broader portfolio. That’s why we expect to see demand not only in fixed income, but in domestic and international equities.

Where do you think ETF investors are becoming more sophisticated? And where specifically do you think education is still necessary?
We’ve been trying to track how ETF education is paying off year-over-year in each region, and it seems ETF issuers need to continue evolving the education they provide for their investors. We touched on smart-beta usage becoming increasingly prominent, but “smart beta” can be a vague term that means different things to different investors.

We’re seeing a need for education to foster a better understanding of how smart beta can be used in a portfolio, what factors are at play and how multifactor products are structured. Married with the idea that investors are weighing demand and index methodology more heavily in ETF selection efforts, this tells us investors will get increasingly technical on the merits of index methodology and how an ETF is going to trade. They’ll be benchmarking ETFs in many factors and want to understand the nuances from manager to manager and product to product.

ETF issuers have moved beyond basic ETF 101 education into more master classes, showing institutions and advisors how the advanced capabilities of smart-beta or active ETF wrappers can fit within their investment strategies. We think this type of education will be where efforts are focused in 2019 and beyond.

Were there any head winds to the ETF industry that were identified in the survey?
Globally, 29% of our respondents highlighted platforms that don’t make trading ETFs easy or economical as a potential head wind. We think the takeaway is the influence and control that a lot of gatekeepers exert—whether they be national broker-dealers here in the States or institutional banks that play an important role in ETF distribution in Europe or in Asia.

We hypothesize our respondents are indicating that they want to see more choices when those centralized gatekeepers select ETFs and put them onto those platforms for wider distribution to their underlying clients. ETF investors are performing their own due diligence on products, and then having a potentially harder time accessing them through their gatekeepers and intermediary partners. Especially when it comes to smart-beta and actively managed ETFs, those intermediaries may want to think differently to make sure they’re providing the choice that their underlying clients seem to be looking for.

The views expressed are a reflection of Brown Brothers Harriman’s best judgment at the time this interview was conducted, and any obligation to update or alter our views as a result of new information, future events or otherwise is disclaimed.