2016: Big ETF Predictions

[This article originally appeared in our January issue of ETF Report.]

ETF Asset Flows To Hit Another Record

The ETF industry will attract record levels of fresh asset inflows in 2016. This is a call that’s pretty easy to make.

If you look at the past three years alone, investors have poured record-breaking levels of assets into U.S.-listed ETFs year after year. And with every passing year, more and more investors are turning to ETFs and finding that they are easy to trade, and are useful for everything from gaining market access, to diversifying exposure, to implementing tactical strategies, to managing taxes.

In 2013, ETFs gathered an impressive $188 billion in fresh net assets. That was a record year. In 2014, we saw an unprecedented $243 billion in net creations—a blockbuster year that cemented the ETF industry as the fastest-growing segment in financial markets.

And by mid-November, 2015 was on track to match—if not exceed—the previous year’s totals despite the muted performance of the U.S. stock market. We were already looking at some $200 billion in net inflows in the first 10 months of the year.

‘Secular Shift To ETFs’
“Despite generally higher volatility and lower returns in 2015, ETF assets have continued to grow at an impressive pace,” said Nick Colas, chief market strategist at Convergex, a global brokerage company based in New York. “Every asset class I track—stocks, bonds, currencies, commodities, etc.—show positive inflows this year. All this tells me that what we’re witnessing a secular shift to ETFs.”

This “shift” is marked by growing investor acceptance of the benefits and uses of ETFs. It’s also being helped by the proliferation of ETFs themselves, which in the U.S. now surpass 1,800 funds. Today if you think of an investing idea, chances are it’s already in an ETF wrapper somewhere.

In the first 10 months of 2015, issuers brought to market a record 238 new funds, and by mid-November, that number had grown to 253. With six weeks to go in the year—the time this article was written—2015 was already on the record books for the second-highest number of new launches in a year.

Another important factor in the rising demand for ETFs is the noteworthy endorsement of key money managers who are entering the ETF space for the first time. We’re talking about the likes of DoubleLine Capital, led by active manager Jeffrey Gundlach; John Hancock; Goldman Sachs (which had previously only launched ETNs); USAA; and even Kevin O’Leary of “Shark Tank” fame, who created O’Shares Investments to bring ETFs to market.

These major institutions and active managers just now entering the space bring with them hordes of loyal clients, who are following them into the world of ETFs for the first time. That’s a trend that’s in its infancy, but one that promises to deliver big in terms of asset flows in 2016.

Fee Wars Will Continue

For the most part, 2015 was a quiet year in terms of fee wars among ETF issuers; that is, until iShares cut fees on seven of its “Core” ETFs in mid-November, some by more than half.

The move was so aggressive—not to say, unexpected—it landed the iShares Core S&P Total Stock Market ETF (ITOT | A-100) in the top spot as the cheapest equity ETF in the U.S. After the fee cut, ITOT cost a mere 0.03% in expense ratio, undercutting all competitors.

What followed was equally exciting: Charles Schwab vowed it would not be undercut, and within days, it too lowered fees on some of its ETFs. Most notably, Schwab matched ITOT’s low price tag by bringing the expense ratio on the competing Schwab U.S. Broad Market (SCHB | A-100) down 1 basis point to 0.03%.

One Direction For Fees
It’s official: The race to the bottom is reignited.

“I think the fee war only goes one direction: down,” said Dave Nadig, director of ETFs for FactSet. “iShares’ move was a declaration of war, and it will spill out from the ‘Core’ products to anything that’s hot.”

In other words, we’ll start to see fee cuts “spill out” beyond plain-vanilla strategies to popular strategies and segments—those that are typically known to cost more, such as smart beta.

In fact, this trend is already budding thanks to Goldman Sachs. The firm, which entered the ETF market for the first time in 2015, with the launch of a lineup of smart-beta ETFs, showed that it was coming into the market to grow assets, and it was going to do that by offering competitive pricing.

Goldman Sachs’ ActiveBeta U.S. Large Cap Equity ETF (GSLC), tracking an index of U.S. large-cap stocks comprising four factor subindexes, came to market at 0.09% in fees. Consider that price tag in the context of other smart-beta funds, which average upward of 0.50% in expense ratio—more than five times the cost. Goldman Sachs is basically offering smart-beta ETFs for the price of plain-vanilla funds.

“While we’ve seen huge product proliferation, we haven’t had huge asset flows to a broad group of them,” Nadig noted. “So, how will newer entrants compete? Price.”

There’s no question that lower fees mean fewer dollars flowing into ETF issuers’ coffers yearly. The idea is that competitive pricing will help grow the asset base, offsetting losses incurred by slashing expense ratios.

“Fee compression and asset growth will always be a push-me/pull-you,” Nadig added. “But I stand by my prediction that, in the next 10 years, ETF assets cross mutual fund assets.”

Smart Beta ETFs Will Attract $100B In Inflows

For the past three years, “smart beta” ETF strategies have commanded plenty of attention in the financial service industry. Since 2013, more than $150 billion in new assets have flowed into these funds. But for 2016, we expect flows to grow at their fastest annual rate to date.

Several elements are lining up for smart-beta ETFs—which are considered to be any fund that is not market-cap-weighted—to attract potentially as much as $100 billion in new assets in 2016.

First, smart-beta ETF will continue to be a go-to tool for advisors. According to the latest ETF.com/BBH survey of financial advisors, 99% of all respondents said that they would maintain or increase their exposure to smart-beta ETFs in 2016. Clearly the demand is there.

Secondly, smart-beta strategies are now migrating more quickly from equity funds to all corners of the ETF universe. Smart-beta strategies have already been established in the fixed-income space, albeit at a much lower profile than with equities. Smart beta is also landing in emerging markets. Investors, who are now quite comfortable with the emerging market space, will begin moving away from broad-based investing models as EM growth continues to show a lot of cracks. There are even new “smart-beta commodity ETFs” coming in 2016.

And then there are major financial service companies like Goldman Sachs, J.P. Morgan and John Hancock entering the ETF space for the first time, and their initial launches are on based multifactor strategies. This last element could be the most important to fuel more smart-beta growth. The firms are bringing with them strong client bases and distribution platforms.

“We agree we will see continued growth for this investment theme,” said Todd Rosenbluth, director of ETF Research for S&P Capital IQ and SNL, adding that the other key driver of growth is how issuers are moving from single-factor to multifactor strategies as Goldman Sachs and John Hancock have done. That, however, will not make an advisor’s or investor’s job any easier.

“When you add multiple factors, it may very well end up being a very good product, and we think many of these will be. What’s inside it is not as easy to understand as with a single factor,” he noted. “You’re going to see quite different products, and you need to understand what’s in the product today, as well as in the past.”

Currency Hedge Stars of 2015 Will Repeat

Soon after the arrival of Abenomics and Japan’s aggressive moves to weaken the yen, the ETF industry’s move into currency-hedged products really took off in 2013 with the WisdomTree Japan Hedged Equity (DXJ | B-70). That year saw nearly $10 billion flow into the fund, as well as being one of the best-performing ETFs of the year.

Weakening its currency to help make exports cheaper clearly worked, sending Japan’s stock market surging. But the next year, as the yen stabilized against the dollar, the trade lost its sheen, and investors retreated, taking more than $400 million out of the fund. But instead of the currency-hedged phenomena fading, the second leg of the trend was just warming up in Europe and other parts of the world.

With the eurozone still mired in a recession, the European Central Bank began signaling it would be launching its own quantitative easing program if needed, which it did in January 2015. That ushered in the second act of the currency-hedged trend and put the spotlight on two ETFs in particular.

Realizing the eurozone was headed for the same monetary fate as Japan, investors began piling into two ETFs toward the end of 2014 that would produce similar results as DXJ: the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-71) and the WisdomTree Europe Hedged Equity (HEDJ | B-49).

While more than $6 billion flowed into those funds then, it was 2015 when DBEF and HEDJ became the new stars of the ETF world as the ECB unleashed its own QE program. Not only did the funds live up to the outperformance promise, DBEF and HEDJ saw $12.7 billion and $15.6 billion in inflows, respectively, through November 2015.

Heading into 2016, the fundamentals for these funds—stronger dollar and weakening euro—have actually improved, which is why we feel these two ETFs are set up for a repeated performance, and will again be the top asset gathers and continue to outperform U.S. stocks.

“We’re on a precipice poised to actually have the Fed zig while the European Central Bank is zagging, and it’s looking very, very imminent,” said Shehriyar Antia, former official at the New York Federal Reserve, and founder and lead strategist of Macro Insight Group, an investment strategy firm based in New York. “We’ve never had stronger signs of divergence in the immediate future than we have now.”

However, he cautions that investors looking for short-term gains could be disappointed.

“If you want to get into that trade, you have to look further out than the next two or three months,” he said. “You have to look forward to 2016. There’s room for the dollar to grow even stronger because of the market being complacent about inflation.”

Schwab Headed For No. 3 Annual Inflows Spot

Charles Schwab has been something of a stealth bomber in the ETF space for the last several years. Launching its first funds back in 2009, the firm now has a lineup of more than 20 ETFs that cover core asset classes, including several smart-beta funds.

That’s certainly not a big fund lineup, but it’s all part of Schwab’s plan, which does not include country, leveraged or sector funds. “We are more in where we believe about two-thirds off the flows are going,” said John Sturiale, senior vice president of product management for Charles Schwab Investment Management.

Right now, Schwab has roughly $39 billion in assets under management in its own ETFs, ranking it the seventh-largest ETF issuer in terms of assets under management; it was also No. 5 in terms of inflows year-to-date as of Nov. 30.

Going forward, we expect flows to gather even more quickly for Schwab, primarily because of its low-cost funds, its vast distribution network and its OneSource platform.

The firm aims to be the low-cost leader in every asset class where it offers an ETF. For example, its Schwab U.S. Broad Market ETF (SCHB | A-100) recently saw its expense ratio trimmed to 3 basis points to match the iShares Core S&P Total U.S. Stock Market ETF (ITOT | A-100). It’s also 2 basis points cheaper than the Vanguard Total Stock Market ETF (VTI | A-100), which is offered by the firm that had been the low-cost leader before Schwab stole its crown.

Certainly, in its commitment to low costs and a limited list of building-block-style funds, Schwab has a lot in common with Vanguard—currently the No. 2 firm in terms of assets under management and year-to-date inflows—in its approach.

However, Schwab’s commission-free OneSource ETF program goes much farther than Vanguard’s, which only includes its own funds. Schwab’s program comprises more than 200 funds from 14 issuers, not just Schwab’s ETFs. That makes it the largest commission-free program currently available, and there’s no doubt it’s driving assets into Schwab funds.

Schwab’s distribution pipeline for its ETFs is also vast, including its retail arm and its advisor network of 7,000 RIAs. There’s also the relatively new Schwab Index Advantage 401(k) ETF platform, where Schwab’s and other firms’ ETFs are marketed to retirement plan consultants and employers. More recently, via its retail operations, Schwab has launched the Intelligent Portfolios robo-advisory service, which builds ETF portfolios for investors.

For all of these reasons, we believe that 2016 will see Charles Schwab move up the leader board to claim the No. 3 spot for ETF annual inflows, just under BlackRock’s iShares and Vanguard.

John Hancock Hits Its Stride

John Hancock burst onto the ETF scene in 2015 clutching what amounted to the holy grail for many passive investors: It introduced a lineup of smart-beta ETFs that tracked indexes provided by none other than Dimensional Fund Advisors.

DFA is famous for its mutual funds and for its embrace of passive investing. It includes the likes of Nobel winners Myron Scholes and Eugene Fama on its boards. And while it’s “passive” in its investment approach, it doesn’t rely on indexes. Instead, its funds use quantitative methods and hold large swaths of their target markets, tilting toward small-cap and value stocks, and stocks with higher-than-average profitability levels.

Offering Easier Access To DFA
However, DFA funds can be hard for investors to get a hold of, as they are only sold through financial advisors that have been vetted and approved by DFA.

That an equally large and respected firm like John Hancock to cut a deal for DFA to modify its strategy to fit an index methodology and manage the ETFs is a coup. The result is that John Hancock has entered the ETF space with a unique value proposition—multifactor ETFs based on strategies from and managed by the firm that basically invented factor investing.

Suddenly, a DFA-generated strategy is widely available to all investors at a low cost and with no restriction on how they trade the products (advisors can be suspended by DFA for moving in and out of its funds too much).

John Hancock, in the launch of its ETF family, also rolled out the first multifactor sector funds, in addition to ETFs covering the U.S. large-cap and midcap spaces. The focus of factor-based funds has, up until now, been on countries, regions and size segments.

Sector Factor Approach
The first batch it launched included only four sectors—financials, health care, technology and consumer discretionary—but the firm has already filed for another five funds covering the other major sectors.

“While we cannot give forward estimates on sales, we subscribe to the belief that we will see increasing use of ETFs across all channels and customers, whether they be the traditional channels, retirement markets or the next generation of investors. At John Hancock Investments, we have high expectations given the pedigree of the two strong brands backing our ETFs,” said Andrew Arnott, president & CEO of John Hancock Investments.

We, however, anticipate that John Hancock will stand out in a crowded field because of these features. While the firm’s ETFs do not have much in assets now, we expect them to draw more attention from advisors by midyear and pull in at least $1 billion in assets by the end of 2016. The asset growth will likely accelerate as the firm rolls out more funds.

Emerging Markets Will Return To Vogue

Emerging markets have been out of favor for some time now. After bouncing back big in the two years after the financial crisis, these markets have been steadily dripping lower, with seemingly no end in sight for the rout in emerging market stocks and ETFs.

This year was particularly brutal, as popular ETFs such as the Vanguard FTSE Emerging Markets ETF (VWO | C-88) and the iShares Core MSCI Emerging Markets ETF (IEMG | A-99) fell to their lowest levels since 2009.

China Hard-Landing Fears
Given the constant negative news in 2015, it’s not surprising that emerging markets have performed so abysmally.

From the bursting of China’s stock market bubble, to Brazil’s worst recession in 25 years, to economic sanctions on Russia, there was a constant stream of bad news for emerging markets. That bad news hit its climax during August and September, when investors panicked that China’s economy could be slowing much faster than anticipated and that a “hard landing” was likely.

Since then, those worst-case fears have abated somewhat, and emerging markets rebounded modestly. Still, emerging markets remain heavily out of favor for most investors, with markets still down significantly from their highs of several years ago.

Improving Growth
With everyone so bearish, perhaps now is the time to take a contrarian view and buy emerging markets. Some noteworthy analysts have come out recently with bullish calls on the space.

“2016 could be the year EM assets put in a bottom and start to find their feet,” said Goldman Sachs. Analysts at the firm cited “the prospect of improved growth and better returns” as reasons to be optimistic.

That’s in line with what the International Monetary Fund is forecasting. The IMF expects growth in developing economies to rebound from 4.2% this year to 4.7% next year.

Valuations Cheap
Aside from the potential for faster growth, another reason to buy emerging markets may be because they’re simply so cheap.

A recent Bloomberg report says the MSCI Emerging Markets Index, the benchmark underlying iShares’ IEMG, is trading at a mere 12 times earnings compared with 18 times for U.S. stocks, suggesting the ETF could be a bargain.

It’s true that emerging markets still have a lot of issues to contend with, and news for the group may remain negative for a while longer, but at a certain point, valuations price in all that and more. We think that point may be now, which sets up the potential for a strong 2016.

It wouldn’t be surprising to see IEMG among the top 10 ETFs for net inflows next year.

Expect Oil Prices To Rebound

We are in the midst of the worst oil bust in decades. The industry hasn’t been in this bad shape since 1999, or even 1986. With prices spiraling to less than $40/barrel, companies have been forced to slash both drilling activities and jobs.

Meanwhile, consumers are rejoicing. The average gasoline price in the U.S. could even fall below $2/gallon, according to AAA.

Things certainly look great for consumers and horrible for producers, but don’t get used to the current situation. Prices are likely headed higher by the end of 2016.

Production Dropping
The biggest culprit for oil’s plunge starting in the middle of 2014 was the enormous growth in U.S. shale production. Output in the country had grown by nearly 1 million barrels per day for three-straight years up until that point. The market simply couldn no longer absorb that breakneck pace of growth.

Prices cratered from more than $100/barrel in July 2014 to less than $45 in early 2015 (later moving even lower, to $37.75 in August).

Compounding the oil market’s problems was a surprise decision by the Organization of Petroleum Exporting Countries (OPEC), led by Saudi Arabia, to increase its production to punish and steal market share away from U.S. producers.

OPEC’s strategy worked, and now U.S. output is tumbling on the back of reduced drilling, with daily production down 500,000 barrels from its high of 9.6 million barrels per day.

Demand Skyrocketing
At the same time that supply struggles, demand is headed the other way. According to the International Energy Agency, consumption is on track to increase by 1.8 million barrels per day this year, the fastest pace of growth in five years. As long as prices stay low, there’s no reason to expect demand to slow down anytime soon.

However, supply continues to outpace demand. The big 2.5 million barrels per-day jump in OPEC production since the middle of last year has outpaced even the massive increase in demand.

But with OPEC now pumping full tilt, the cartel is effectively maxed out.

If demand rises another 1.5 million barrels per day or more in 2016, that could finally shift the oil market into a deficit, lowering inventories and sending prices spiking.

Pira Energy Group, a firm highly regarded for its energy price forecasts, says that it takes nine months for U.S. companies to bring new production on-stream once it becomes profitable to drill again.

The firm suggests that oil will climb to $70 per barrel by the end of 2016, a whopping 75% increase in prices from current levels that would also likely benefit energy and oil-linked stocks and ETFs.