3 ETF Predictions For The 4th Quarter

With four months left to a crazy year, here are three ETF surprises in store.

We love making predictions around here. After all, Matt Hougan and I predicted in February that the ETF market was going to cross $15 trillion by 2024. Maybe it’s because we’re not in the business of making market calls. Or maybe it’s just that nobody can resist reading tea leaves when it comes to investing, no matter how academic the approach.

Matt and I recently chatted about what we thought the big stories for ETFs were going to be in the fourth quarter of 2014. Here’s what we came up with:

1) ETF assets will cross $2 trillion

With assets currently sitting at around $1.9 trillion, this seems like a bit of a no-brainer. Flows haven’t come in a straight line this year by any means, and investors seem to be capricious regarding where they’re allocating. All signs, however, seem to point toward a traditional end-of-year pop for ETF flows to add to the $103 billion that has flowed in so far this year.

One of the traditional sources of flows is tax-loss harvesting, something that may be less relevant to mutual fund investors this year. It’s been a good year in general across most asset classes, with just a few pockets of actual negative performance. According to Morningstar, the average Europe fund is down a few percent, as are funds focused on small-cap growth. But almost every traditional equity category is at least positive for the year.

But, importantly, there are trillions of assets in active funds that have underperformed this year.

According to Morningstar, the average large-cap growth fund is up just over 7 percent year to-date, versus 9.4 percent for the S&P 500 Index. In fact, not a single category of U.S. equity funds has beaten the S&P 500 so far this year.

Of course, some individual funds did: You might have been lucky enough to be in the Snow Capital Focused Value mutual fund (SFOIX), and been up more than 16 percent. But you paid 1.15 percent to get there, and if you just wanted an aggressive take on value, you could have bought the Global X SuperDividend ETF (DIV | B-37), which returned almost 18 percent, at less than half the price.

The point is this: Investors are continuing to realize that they’re overpaying for underperformance in actively managed mutual funds, and eventually, that money finds a home in ETFs.

Could the market correct and drop asset levels? Of course.

But barring the kind of panic being called for by David Tice, I think we’re on target for $2 trillion by year end.

2) Nontransparent active will be approved

Speaking of active management, I believe this is the quarter where the first nontransparent active ETFs will be formally approved by the SEC. The rash of filings based on Precidian Investments’ intellectual property has been impressive, and the American Funds filing joining the Precidian plan was the writing in the wall to me.

With virtually everyone in the industry lined up behind the blind-trust approach to shielding portfolio holdings, and the former head of the Security and Exchange Commission’s Investment Management Division putting his own name on the filings, to me, it’s a foregone conclusion.

The question for handicappers is, Who will get approved first? My guess is that we’ll see approval on the first filing of the bunch from BlackRock dating back to the summer of 2011. Given that essentially all the applications are identical, it’s reasonable to assume a “first in, first out” approach on these kinds of things.

The second question is, Are these good for investors? Matt and I debated this a bit on the podcast, but ultimately the answer is that the ETF versions of active strategies will likely be better than the mutual fund versions. I still remain a huge skeptic on traditional stock-picking active management, but if you’re going to do it, the ETF wrapper at least offers mechanisms to manage taxes, lower costs and provide intra-day flexibility.

3) The rebirth of emerging markets

After the heady few years we’ve had in developed markets, many advisors we talk to are getting itchy fingers and looking for better value. Matt and I both agree that nondeveloped markets are going to be the benefit of those nerves, but we differ on where.

I think the winner is likely to be funds like the iShares Core MSCI Emerging Markets ETF (IEMG | B-99). I’ve got some smart people on that bet too, including Don Luskin in our Alpha Think Tank, who said just this last week:

“At the same time, politics aside, one of the things emerging markets have in common is they need lots of foreign capital, and they want that capital to be steady and sticky. The new Yellen doctrine—which is promising not zero interest rates, but low interest rates basically forever—is a very wonderful thing to tell emerging markets, because under that kind of doctrine, if you’re the Treasury of one of these emerging market governments, you can now issue debt with a lot of confidence that you won’t be facing a lot of fast money that’s going to pull the rug out from under you, because the Fed is basically going to be loose for 10 years.”

That’s the kind of broad motivation for markets I believe in, and I think the low-cost, broad exposure of IEMG and competitors like the Schwab Emerging Markets Equity ETF (SCHE | B-87) is exactly what investors should own. Flows recently would suggest the move already: IEMG pulled in more than $630 million in the third quarter, and SCHE pulled in $77 million. A lot of that flow has been just in the past week.

Matt, on the other hand, thinks investors are wary of trying to balance out the seeming unstoppable developing markets like India against the turmoil-stricken ones, like Russia. The winner, he suggests, is frontier markets ETFs like the iShares MSCI Frontier 100 (FM | D-75). The theory is that the global political landscape looks better for Kuwait and Nigeria and the UAE than it does for Russia and Brazil, and he may be right.

The problem with frontier markets in general is access: FM doesn’t trade particularly well. It’s also subject to fairly consistent premiums because the underlying securities are more difficult to get than traditional emerging markets stocks. Those premiums evaporate when people want out:

Still, flows have been picking up: FM has added $132 million in the third quarter, and it too, I suspect, will blossom as we head to year-end.

And here’s one bonus prediction: The pace of ETF filings and launches will continue unabated. A total of 123 new ETFs have launched this year so far, and that pace seems to be increasing by the week.

At the time of this writing, the author held a position in SCHE. Contact Dave Nadig at [email protected] or follow him on Twitter (which he doesn’t own either) @DaveNadig.