ETFs' Future: Huge Growth

February 04, 2014

Exchange-traded fund assets will top mutual fund assets within 10 years, and we’re making ETF Analytics free. Here's why.

Last week, we announced the launch of and presented our vision for the future of ETFs during our annual keynote presentation at the 2014 Inside ETFs conference.

We made some bold predictions and significant announcements at the conference, including:

  • ETF assets will top mutual fund assets within 10 years
  • We are rebranding as
  • will offer its $2,000/year ETF Analytics service to all investors for free

The announcements raised quite a few eyebrows and elicited a lot of questions. We thought we would explain our reasoning here.

What follows is a digest of our keynote presentation. It is intentionally rough and conversational, as was the keynote itself.

A Battle For The Soul Of Investing

We believe we’re in the throes of a battle for the heart and soul of investing. Like all good battles, this one is also between good and evil. Specifically, it’s between those that would make investing cheaper, more efficient and more effective and those that would claw back money through false hope, distribution fees and slick marketing materials. Our goal with is to make sure the good guys win.

Our vision for how that happens and our rationale for making ETF Analytics free is not complex. In fact, it’s based on three simple concepts:p

  1. The ETF revolution is really just getting started.
  2. There are some bad things happening that concern us, and could derail the growth and positive change the ETF revolution is bringing about if they’re not dealt with.
  3. The key to the future is leveling the playing field for investors, and we aim to do just that.

Let’s walk through each one of these three.

The ETF Revolution

First, a bit of a history lesson, so we can put our prediction about ETF asset growth in context.

ETP Asset Growth

Here’s a chart everyone’s seen at least once by now. It shows ETF assets under management by year since the day the S&P 500 SPDRs (SPY | A) started trading in 1993. Let’s talk about where this impressive growth came from.


ETP Asset Growth

When the first ETFs came to market, they were built for a very specific reason—to give institutional investors easy access to liquidity. SPY, for instance, allowed investors to trade the S&P 500 stocks with one trade, rather than 500.

This focus on institutional liquidity persisted in the launches that followed SPY. The first real batch of funds to launch were called the WEBS, or World Equity Benchmark series. These funds, launched by Morgan Stanley, and later acquired by Barclays Global Investors, targeted a wide range of countries from Argentina to the United Kingdom. They allowed institutional investors to equitize cash and gain quick-touch exposure to critical markets.

Toward the end of this period, starting in the late 1990s, we saw another group of investors pile in: active traders. There was a time when the Nasdaq 100 ETF (QQQ | A - 64) was the most actively traded security on the market, during the heart of the dot-com boom. But those two groups defined the growth we saw in the first decade of ETFs: trading, both by institutions and retail.

ETP Asset Growth

As we entered the 2000s, and as BGI (now BlackRock) started to invest in growing the market, we went into the true early-adopter phase. Here we started to see the first big moves by the advisor community.’s progenitor website,, came into being. The Inside ETFs conference started. We saw the first books published targeted at teaching advisors how ETFs worked. We saw the first advisory firms start actually marketing themselves as ETF-only or ETF-centric.


In the beginning of this period, when we looked at surveys of advisor use, it showed usage in the low teens on a percentage basis. At the end of this period, that number was closer to 50 percent.

This phase also saw more sophisticated individual investors using ETFs, and frankly that’s where things got a little wonky. We saw the rise of more complex ETFs, like leveraged and commodities products, and we had some scary headlines. Folks like FINRA had to step in and start issuing new guidance. But this was really the beginning of broad ETF adoption.

ETP Asset Growth

And this is the last few years. Bolstered by marketing budgets, rising markets and the continued failure of actively managed mutual funds to deliver, ETFs started to actually crack the code with the doubters. New transaction fee programs start making things more accessible for retail investors. We saw broker-dealers and RIA shops that had previously shunned ETFs started getting on board.

Suddenly, this was not just a trader’s tool or a niche product for advisors. Suddenly, we had all three guests at the table: the institutional investor; the advisor; and the retail investor.

Where does that take us for the next leg of the ETF revolution? A simple linear projection of the last few years would suggest an ETF market of more than $5 trillion within 10 years.

Honestly, we think that’s sandbagging the real growth. We believe ETF assets will eclipse mutual fund assets within 10 years. Simply doing that, with some modest expectations about global market growth, puts ETF assets at more than $15 trillion by 2024.

ETP Asset Growth

We don’t expect anyone to take this prediction at face value. It’s a big number. But we think there are significant trends in place that, taken together, more than justify this prediction.

Previously, ETFs only made sense for a portion of the investing market. But we now think that ETFs have developed to the point where their five key benefits apply across the spectrum to institutions, advisors and individual investors alike. This is the first time that’s ever been the case, and it’s an absolute game changer.

Taken together, the penetration into all three groups will drive ETFs to be larger than mutual funds within 10 years.



ETFs have always been a great hit with advisors and retail investors because they are low cost. Part of that is because they are index funds, and index funds are much cheaper to run than actively managed products. But part of it is the structure—after all, ETFs are cheaper even than traditional index funds.

How much cheaper? Well, the average large-cap equity ETF charges 44 basis points, and the average large-cap equity mutual funds charge 1.37 percent. That’s less than a 1 percent difference, leading some to ask, What’s the difference?

We think it’s enormous.

How Much Are ETF Investors Saving?

Let’s take just three asset classes: U.S. equity, international equity and fixed income. If you look at the simple average expense ratio of ETFs in each of these asset classes, and you look at the amount of money invested in ETFs, you’d have ETF investors paying about $7.2 billion in fees.

If that same money was invested in mutual funds, you’d be talking $21.9 billion in fees. To put it another way, ETFs are taking $14,761,866,000 every year out of the coffers of Wall Street and putting it into the pockets of investors around the world.

That’s $40.4 million per day, or about $500 a second. In the time it’s taken you to read this, ETF investors have saved about $50,000 versus where they would be if they invested in mutual funds. That kind of money matters.

But we all know that story. The story we don’t know is about institutions.

Institutions have always been big users of ETFs. But historically, they’ve had a very short-term focus. They’d use ETFs for what they call “cash equitization” and “transition management.”

That means if they had a bunch of cash—say, a new investment—and they quickly wanted to get exposure to the market, they’d park it in ETFs. Or if they were firing one active manager and didn’t know yet who they were going to hire as a replacement, they’d park it in ETFs for a while.

No self-respecting institution would take a long-term position in an emerging market ETF, because if they wanted long-term exposure to emerging markets, Wall Street managers would fall all over themselves offering to do it for very little money.

ETFs are cheap, but when you’re a big institutional investor, you can get plain-vanilla index exposure really cheap.


Institutional Holding Periods

But look at what’s happening. This is the Greenwich Associates annual report on institutional use of ETFs. As the cost of the ETFs has come down, 36 percent of institutions now say they use ETFs for periods of longer than two years. Five years ago, that was zero.

Here’s what the actual quote from their report says:

Although ETFs first entered institutional portfolios mainly as tactical tools … many institutions indicate they are beginning to regularly use ETFs for many additional purposes, including gaining long-term exposures and implementing investment strategies.

And if you don’t believe Greenwich, just consider something we all saw this year, when the Arizona State Retirement System and its $20 billion in assets teamed up with iShares to launch a series of factor ETFs because that was the cheapest way to get liquid exposure they could find.

It took them three years of business development efforts to launch the funds, but they still felt it was worth it. This is what the co-CIO of ASRS, David Underwood, said when we interviewed him for the Journal of Indexes: “We had not used ETFs in any meaningful fashion previously … [but] very much to their credit, iShares … priced these ETFs at 15 basis points.”

It’s a trend we see repeating itself over and over again in the year to come.

In short, the case for cost savings has always been there for advisors and individual investors, and now it’s truer than ever for institutional investors as well.



The record for ETFs on taxes is nearly flawless:


This data, which is from our friends at Morningstar, looks at the average annual capital gains distribution from active mutual funds, passive mutual funds and ETFs tracking the equity markets for 10 years through 2011.

It’s not just that ETFs are better, they’re literally infinitely better. I don’t know which emerging market ETF blew the average there, but I’ve got a bone to pick with them.

The reason ETFs are so much more tax efficient than mutual funds is simple: Traditional mutual funds are one of the least tax-fair investment products ever invented.

The emerging markets funds cited above had to pay out so much because the funds held a lot of embedded gains at a time when investors wanted out. When investors cashed out, the funds had to sell those stocks with big gains, and then, by law, they have to pay out those capital gains to all of the shareholders that remained.

It’s a scam. If the tables were turned and it was the ETF structure that caused these horrible tax outcomes for investors who’d done nothing but have the temerity not to sell, there’d be scandalous headlines and congressional hearings.

Investors know this.

Average Mutual Fund Flows By Month (2007-2012)

Courtesy of the Investment Company Institute, here’s the average mutual fund flows by month over five years. The pattern here is unmistakable—investors bail out of their funds at the end of the year to avoid getting capital gains distributions, and pile back in in January. It’s insanity. It’s probably no surprise that ETFs have solid flows in November and December. We’d like to think that’s investors getting smarter.

It’s true that most institutions don’t care about the incredible tax efficiency of the ETF structure, but for individual investors and advisors, this tax story is getting out, and we think it will accelerate growth.



ETF trading remains a key differentiator, and currently ETFs represent about 25 percent of value traded each and every day.

ETF Trading Activity

The tradability of ETFs has been a major driver of adoption for all investors. But the past few years has seen a sea change in ETF tradability. In many corners of the market, you can now find an ETF that’s substantially more liquid than the underlying securities it tracks.

Average Spreads

Investors trying to cobble together a basket of the Russell 2000 stocks one-by-one-by-one will pay more than 0.20 percent by the time they finish, but they can trade the iShares Russell 2000 ETF (IWM | A-82) for 0.01 percent in spreads all day long.

This is another game changer, especially for institutions. With their supercharged liquidity—better, in many cases than the underlying—ETFs can be the most efficient means to access different areas of the market even taking into account higher expense ratios.

The number of funds qualifying as super-liquid grows each day, and their exquisite liquidity is becoming a win-win for everybody.



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.


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.


The 10 BP ETF Portfolio

Now, you can go to Schwab and buy this portfolio. It’s a diversified, aggressive portfolio covering 3,000 stocks, 700 bonds and 30 commodities. A few years ago it would have made an institutional investor weep because the blended annual expense ratio is 0.10 percent. And you can trade it, and rebalance it, commission free.


Or if you’re over at Fidelity, you can own this portfolio—you lose the direct commodity exposure, but you still own the total fixed-income and equity markets. It’s amazing exposure, and you can trade it commission free, for 11 basis points.

The 39 BP ETF Portfolio


Or if you’re a bigger player, you can decide to dial it up a notch, and take advantage of some of the innovation in the space. You can anchor yourself in U.S. equity with the iShares Quality ETF (QUAL | A-68), the one they developed for the Arizona Retirement System, talking almost a Warren Buffett approach to the market.

You can get your international equity exposure abroad with a currency-hedged wrapper, to protect against a falling euro (DBEF | C-51). You can tilt toward the dividend payers in emerging markets (DEM | D-76), and layer on direct Chinese A-share exposure (ASHR), because A-shares are trading at a discount to H-shares for the first time in a generation.

Then in the bond space, you can hire Bill Gross to run the bulk of your portfolio (BOND | B), layer in senior loans (BKLN | B) and a short-term high-yield bond play (SJNK | C-98). You can buy hedged and complete international bond exposure (BNDX), get one of the best commodity funds on the market (DBC | B-69) and you can do all that for 39 bps.

Or you can hire a firm like Wealthfront—a well-funded startup in Silicon Valley that offers very-well-built portfolios of ETFs, managed by investing legend Burton Malkiel, with constant tax-loss harvesting and no trading or custody costs. For the first $25,000 you invest with Wealthfront, it charges exactly 0.00 percent in fees. It charges 0.25 percent for everything above that.

All of these aspects are making ETFs truly and universally attractive to retail investors for the first time. And it’s going to make assets soar.


Not everything is completely rosy, however. ETFs are in a gold-rush phase at the moment. And in a gold rush, anyone can show up by the side of the river with a pan.

This makes us nervous. We have four big concerns that we think could hinder the growth in the ETF industry.

Toxic Products

With product proliferation comes the ever-increasing chance that people end up in products that don’t do what they think they’ll do. The industry is in general well-regulated and pretty good at labeling, but there are still many opportunities for confusion.

Take products that invest in futures, for example, like the iPath S&P 500 VIX Short-Term Futures ETN (VXX | A-54). VXX does exactly what it says it’s going to do—tracks a blend of short-term VIX Index futures. But many advisors have piled into VXX thinking it will be a medium- or long-term hedge against downturns in the U.S. equity markets.

In fact, since its launch in 2009, VXX has lost nearly 100 percent of its value due to contango in the futures market. Similar things have happened to investors trying to track heavily contangoed markets like natural gas. These products can poison the well with retail investors and advisors, and the industry will need to maintain a serious focus on education to avoid blowups and bad headlines.


Half Of ‘Smart Beta’ Is Probably Junk

A few years ago, we didn’t even use the term “smart beta,” but the idea has been around for a long time. Go find a bunch of factors, use them in your weighting and selection techniques, build a model and wedge them into an index.

In the 1990s, we just called these quant strategies. Now we call them “smart beta.” We dedicate an entire upcoming issue of the Exchange-Traded Funds Report to these funds, and in it we highlight a few big issues.

The first one is crowding. For a few years, it seemed like buying the less risky stocks in the S&P 500 paid more than buying the riskier stocks. That goes against the fundamental math of the capital asset pricing model, so it was called the “low-vol anomaly,” and people piled into products like the PowerShares S&P Low Volatility ETF (SPLV | A-47) … until it stopped working.

Why did it stop working? Likely because everyone piled in, and once everyone had finished piling in, those stocks went back to just performing like they should—the sleepy part of the S&P 500. These are not bad products, but investors need to understand what they’re buying.

One concern that is more worrisome: Strategies that try and beat the market generally incur increased trading and execution costs. That shows up in bad tracking, which can add insult to injury in products that are often multiples more expensive than vanilla indexing.

Last, many of these products simply don’t trade well, and as theoretical “buy and hold” alpha generators, they can trade at significant discounts and premiums based on flows.

We’re not saying no smart-beta product is any good. We’re just saying it’s a giant “buyer beware” area of the market.

Pay To Play

But if half of smart beta is junk, at least you can avoid it. Far more pernicious are the trends we’re seeing in the pay-to-play space.

Let’s start with the obvious. Zero commission doesn’t mean zero cost. Discount brokers aren’t creating and running commission-free programs for their health. BlackRock/iShares, State Street Global Advisors, PowerShares and everyone who is participating in these programs is paying money to the brokerages to do it, in some form or another. And while we haven’t seen fees going up yet in the ETFS offered under these programs, it’s worth keeping an eye on.

What’s worse is what we see happening to the recommended lists at major broker-dealers and institutions. There was a time—and this is still largely true—when these lists represented the true best thoughts of the people in these firms.

But these lists drive assets, and there’s increasing chatter in the industry about deals—whether through direct payments, revenue sharing or other means—for ETFs to get onto these recommended lists or into unified management account programs. It’s a very worrisome trend, because it means the best choices may not rise to the top.

And finally, for as much as we love the ETF strategist revolution, all those trail fees are taking us a little bit back into the mutual fund era, where you get what you pay for.

A survey of the portfolios of ETF strategists shows everything from well-thought-out asset allocation programs to shoot-the-lights-out market-timing bets that flip flop between levered positions.

In other words, it’s the same diversity of sanity and talent you’d expect to find in any large collection of managers. There’s nothing about bolting “ETF” on the front of your active management strategy that will make it better.


Leveling The Playing Field

So what’s an investor to do? And what are we going to do?

As we looked at the state of the industry, the enormous growth potential and the stumbling blocks, we realized something: The good guys have to win.

If ETFs are going to fulfill their potential and exceed mutual funds on an asset basis within 10 years, people have to be able to find the right products and they have to be happy with the results when they do.

And for us, that’s opportunity. We, as a firm, will be successful if investors get all of the benefits of ETFs and manage to avoid the pitfalls, because the growth in the space will be absolutely enormous.

All that is why we decided to take the $2,000/year, institutional-caliber product that we’d been designing for three years—which we’ve been selling successfully to the world’s smartest ETF strategists, advisors and institutions—and make it available to anyone who bothers to type in “” or “” into their browser. For free.

We’ll be honest. More than a few people think we’re nuts. Some have asked if we give preferential treatment to ETF issuers for a fee (the answer is obviously no; our scores are completely quant-driven, and our commentary is nothing but blunt and unbiased).

The reason we made the switch to free is simple: If the good guys win, we believe that we’ll be at the center of something pretty special—a revolution in the way people invest. Occupying that space will be enormously valuable.

We’ve got enough faith in this that we’re willing to give our away best work, in a Silicon Valley-style play for audience and airtime. We aim to win, and to be the dominant source of information on ETFs in the world.

Of course, we’d love it if you come to our conferences, subscribe to the Exchange-Traded Fund Report, support our advertisers, or maybe check out our new Alpha Think Tank, where you can get insights from some of the best macro managers in the world for less than the cost of a fancy coffee a week (email [email protected] for a sample).

But even if you don’t, we hope you’ll use our tools and our website. So before you buy your next ETF, type it into your browser using the simple convention we’ve developed——and see if we rate it an A or a B. If not, read the commentary and discover why, and decide if it’s worth buying, or if the risks outweigh the rewards.

Better yet, start your ETF research with our finder ( and use our screens to find the best ETFs for you.

In short, help us make sure the good guys win. We think it will be a mutually beneficial relationship … for years to come.


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