THINKING: Perspectives

An ETF Named DSRE: The Explosive Growth of ETFs May Just Be Getting Started

An ETF Named DSRE:  The Explosive Growth of ETFs May Just Be Getting Started

Exchange traded funds (ETFs) are arguably the single most ground-breaking development of our generation in financial services. This century began with fewer than $100 billion in ETF assets under management and now counts $5.1 trillion in AUM across an ever-expanding number of products. From 2009 through 2017, global ETFs grew at an organic annualized rate of 19%, easily outpacing the 4.8% growth rate for other open-end fund types.[1] According to BlackRock, global ETF assets are poised to more than double, to $12 trillion, by the end of 2023. Extending ETF’s annual organic growth rate 10 years into the future points to assets possibly topping $25 trillion by the end of 2027.[2] Given this growth history and forecast, an argument can be made that the massive disruption of the ETF revolution, which began in the early 1990’s, is just now hitting its stride.

Driving this expansion is the versatility of the ETF investment vehicle. ETFs are being adopted in portfolios alongside, and in some cases in place of, individual stocks and bonds. Global institutions such as insurance companies, pension funds, asset managers and endowments increasingly use ETFs as tools for tactical investing in addition to long-term investments. Greenwich Associates reports one-third of U.S. institutional investors surveyed in 2017 plan to increase ETF allocations over the coming years. A separate Europe-focused survey found that 40% of institutions plan to increase their ETF allocations as well.[3] This growth could accelerate if continued increases in volatility, like the second half of 2018, place a premium on ETF features, including enhanced liquidity, operational efficiency and lower costs.

Lastly, trading in ETFs regularly accounts for about a quarter of the daily volume in U.S. stock markets, but that can leap to nearly 40 percent on some days. These spikes typically coincide with surprise events or policy changes, with ETFs providing a speedy way to pursue a new opportunity or protect against emerging risks.[4]

This paper highlights five reasons why the explosive growth of ETFs may just be getting started.

Reason #1: The Structural Advantages of ETFs

ETFs have become a practical avenue when seeking outcomes that differ from the broad market. Investors are likely to step up their use of ETFs as building blocks in asset allocation and as vehicles to deliver factor-based investment strategies that seek to emphasize persistent drivers of return.

To understand this growth—and continued potential—one needs to understand the fundamentals of ETFs and the broad advantages that ETFs provide compared with other investment vehicles:

  • Access–ETFs are a true democratization of investment access and capabilities. With them, investors can construct sophisticated global strategic allocations in all asset classes in ways that were previously available only to large institutional investors, such as pension funds. Furthermore, ETFs make available to all investors areas that were barely accessible to institutional investors, such as frontier markets and emerging market local currency bonds. Finally, investors can construct tactical allocation strategies that incorporate a wide range of approaches that combine disparate asset classes and sub-asset-class slices based on style, size, and sector.
  • Transparency–ETFs provide a huge leap forward in transparency. Investors know what is in their portfolios, and even the naming of funds is greatly simplified.
  • Liquidity and Price Discovery–Price discovery is especially vital for the smaller, less-liquid segments of US equities, foreign markets (especially when they are closed), and many corners of the fixed-income market. For foreign stock markets, especially during times of financial crisis, even knowing the right price can be challenging. For example, during the global financial crisis of 2007–2009, which featured wild volatility in both equity and debt markets, ETFs were often the most reliable price signals, especially for certain types of fixed-income securities.
  • Tax Efficiency and Fairness–ETFs have revolutionized the efficiency and equity of tax treatment for investors. ETFs generally can provide in-kind redemptions by delivering a basket of securities and thus rarely need to make capital gains distributions. This feature allows most ETFs to avoid taxable events that arise from selling securities for cash within the fund. Not all ETFs are so tax efficient, however.

Reason #2: The Rise of Smart Beta ETFs

A smart Beta ETF uses alternative index construction rules instead of the traditional methodology of weighting by market capitalization. It considers factors such as size, value and volatility. For example, instead of holding shares of companies in proportion to their market value, a smart beta fund may hold them in proportion to some other measure such as sales, dividends, or book value. Smart Beta ETFs utilize both passive and active methods of investing – passive, because it follows an index that specifies it follows a rules-based methodology similar to an index product, but active in that it considers alternative factors. Below are four types of Smart Beta ETF strategies:

  • Equally weighted indexes: Instead of weighting standard indexes based more on price and capitalization, this strategy takes all factors equally into account.
  • Fundamentally weighted indexes: Companies are selected and weighted by such factors as total earnings.
  • Factor-based indexes: Using this method, stocks are weighted, but this method can also separate factors into tiers and equally weigh each factor in each tier.
  • Volatility indexes: Indexes are weighted based on their historic volatility and can give exposure to high or low volatility.

Institutional investors are making greater use of ETFs in strategic portfolio functions. They are using ETFs to obtain investment exposures in “core” portfolio allocations, and as building blocks in top-down strategies that create alpha through asset allocation, as opposed to security selection. They are also employing ETFs to guard portfolios against volatility—a task growing numbers of institutions are addressing with smart beta ETFs. For example, both ETFs and mutual funds involve packages of securities in a fund.

Reason #3:  The Popularity of Fixed Income ETFs

Institutional investors are planning the biggest allocation increases in fixed income, where they are using ETFs to enhance liquidity and otherwise prepare for a new era of “quantitative tightening.” ETFs linked to bond indexes increasingly offer solutions to investors who are adjusting to structural shifts in the way individual bonds trade. These changes mean that investors of all types may increasingly adopt bond ETFs for liquid, efficient exposure over the next decade.

The first fixed income ETFs launched roughly a decade after the first equity ETFs, and assets relative to equities reflect their youth. At $550 billion, the U.S. bond ETF market is roughly one-fifth the assets of U.S. equity ETFs; in Europe, bond ETF assets are $184 billion, about one-third those in equities.[5] However, money is moving into bond ETFs at a faster pace than equities in both regions. Over the past five years, organic annualized growth in bond ETFs expanded at rate of 19% in the U.S. and 24% in Europe, compared

with 16% and 14% in equities, respectively.[6]

Reason #4:  Indexes–Passive vs. Active Management

The term “passive investor” has evolved over time. Today, investors in many index funds aren’t content to go with the flow like boats in the water. Instead of trying to beat the market by picking stocks, portfolio managers are trying to do it by picking indexes. They’ve been aided in this by the rise of ETFs.

Most ETFs are considered “passive” because their managers don’t have discretion in choosing stocks, but they’ve allowed investors to bet on almost every conceivable sector, asset type, and geographic region. According to the Index Industry Association, more than 3.7 million indexes exist—and though most don’t have funds tracking them, it goes to show how flexible the idea of passive management has become. “Indexes have mutated into a form of what they’ve long been used to judge: active management,” says Ben Johnson, director of global ETF research for Morningstar.[7]

The rise of index funds isn’t only changing the asset management business; it could also be influencing how public corporations are managed. Index fund managers have over time been provided more incentive to push for improvements in corporate governance than an active investor does, because they generally don’t have the option to bail out of a stock when they don’t like the way executives are steering a company.

The evidence suggests that while the amount of money in U.S. stock index funds could soon surpass the amount in actively managed ones, “passive” funds are being used more and more for active management.

Reason #5:  ETFs for Every Asset Class and Investment Strategy

The myriad asset classes that ETFs have opened for all investors is comprehensive and highlights how the ETF vehicle has changed access for investors; equity ETFs, fixed-income ETFs, commodity and commodity equity ETFs, currency ETFs, alternative ETFs, leveraged and inverse ETFs, currency-hedged equity ETFs, and commodity stock ETFs. And who knows what’s coming next.

And then there is the rise of factor-based, alternatively weighted and smart beta indexing and ETFs. Some confusion still afflicts the ETF industry about “smart beta” and how closely it is based on enhanced indexing and earlier versions of alternatively weighted indexes. Smart beta is, in many ways, enhanced indexing but is now baked into index construction and design.

Lastly, the idea of ETF managed portfolios is also a revolution that is just getting started. There is the increasing use of index-based ETFs, asset allocation models with ETFs, and the growth of “ETF strategists” who use index-based strategies in actively managed portfolios. Given the efficiency of ETFs, investors and their advisers can be as active as they want to be. These new investment services could not exist if not for the liquidity, transparency, and ultra-low cost of index-based ETFs

Summary

The historical data and underlying fundamentals suggest that the growth in popularity of ETFs won’t abate anytime soon. They are providing a significantly more diverse range of investor sophistication with the chance to convincingly participate in financial markets, as well as arguably creating a new market paradigm in which it will seemingly take greater efforts by active fund managers to identify and exploit those market-pricing anomalies that yield favorable gains. “The ETF industry is growing because of the needs of the marketplace,” says Dustin Lewellyn, Chief Investment Officer of Penserra Capital Management. “ETF investing has evolved from tactical implementation to strategic advantages. What was once a satellite investment has now become a core.”

Moreover, ETF growth may also continue to create new types of market distortions, thus presenting additional opportunities for professional investors to capitalize on undervalued securities. Like BlackRock’s forecast in the opening paragraph of this story, PwC (PricewaterhouseCoopers) projects ETFs to more than triple in asset value to more than $23.2 trillion by 2020, which would account for more than one-fifth of the $112 trillion of assets managed around the world.[8] If so, then one can reasonably conclude that the age of the ETF is well and truly in full swing.

[1] “A Play on the Growing ETF Industry,” Marketwatch.com, May 2, 2018.

[2] “Four Big Trends to Drive ETF Growth,” BlackRock White Paper, May 2018.

[3] ETFs: Valuable Versatility in a Newly Volatile Market,” Greenwich Associates, April 24, 2018.

[4] “How ETFs Became the Market,” Bloomberg, September 13, 2018.

[5] “Four Big Trends to Drive ETF Growth,” BlackRock White Paper, May 2018.

[6] “Four Big Trends to Drive ETF Growth,” BlackRock White Paper, May 2018.

[7] “Index Funds Are King, But Some Indexers Are Passive-Aggressive,” Bloomberg News, January 24, 2019

[8] “Exchange Traded Funds (ETFs): Outlook 2020, PWC Whitepaper, January 2016.