ETFs' Future: Huge Growth

February 04, 2014

Diversity

With more than 1,550 ETFs on the market covering every corner of the investable world, it would be easy to think that the age of innovation was done. And while it’s true there aren’t many plain-vanilla equity indexes left to launch, the pace of innovation isn’t stopping. With more than 1,000 ETFs in registration, the floodgates are opening.

In addition, ETFs are expanding their reach to target new corners of the market. Many of the newer products fall into the categories of “smart beta” or are just full-on traditional active management. There are filings from all over the old guard, from USAA to T. Rowe Price to Eaton Vance and Janus.

While we’re generally fans of passive investing, we recognize many are true believers in stock pickers, so the dawn of these new users is going to drive growth going forward.

To put the importance of this in perspective, consider this: Investors have voted with their feet to the tune of putting $1.7 trillion in ETFs. But they’ve put $2 trillion into the hands of Pimco alone, betting largely on Bill Gross’ take on active management.

We expect one of the several nontransparent active structures will be approved by the SEC this year, and the first products will launch later this year or early in 2015. The entry of these products will complicate ETF analysis, but also bring a horde of new investors to the table.

Distribution

The changes in ETF distribution are where we think the growth really kicks in.

The best estimates say that institutions own about 50-55 percent of ETF assets, but that only about 18 percent of institutions own ETFs. You can see the math right there.

Part of the reason is that ETFs are just now becoming core holdings for pensions and endowments, as discussed previously. But part of the reason is because of silly barriers that have kept major portions of this market out.

Until last year, for instance, insurance companies basically couldn’t own bond ETFs, because of a silly accounting rule that counted all ETFs as “equities,” which meant insurance companies had a larger capital charge on their books.

Now, bond ETFs count as bonds, and insurance companies are diving in. In fact, several of the major launches last year were actually bespoke institutional products designed to serve the needs of single institutions. In short, ETFs have become a viable wrapper alternative for separately managed institutional accounts. That’s powerful.

The advisor-intermediated market is about to explode as well. ETF penetration is strongest into the advisory market, but until a few years ago, there were huge segments of the market that didn’t want anything to do with ETFs. Raymond James, Cetera and LPL—just to name three companies with 26,000 advisors and almost $1 trillion in assets—a few years ago wouldn’t touch ETFs with a 10-foot pole.

Why? Because mutual funds paid them a fee whenever these firms’ advisors put one in a client portfolio, but ETFs paid them nothing. But with the rise of ETF strategists—folks who build portfolios of ETFs that other advisors can follow, and who do pay-trail fees inside these broker-dealers—the growth is tremendous. This segment has gone from $0 to $80 billion in two years, and it’s growing from there.

And then there’s retail. Until a few years ago, ETFs really didn’t make sense for most retail investors. Dropping $1,000 a month into ETFs was a sure-fire way to destroy all of your returns with commission payments. Now most major brokerages have some sort of commission-free trading program.

 

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