What's next for the ETF industry—and your portfolio

  • By Crystal Kim,
  • Barron's
  • Investing in ETFs
  • Exchange-Traded Funds
  • Investing in ETFs
  • Exchange-Traded Funds
  • Investing in ETFs
  • Exchange-Traded Funds
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When exchange-traded funds first arrived in the early 1990s, they were primarily tools for professional traders and investors. ETFs certainly weren't expected to make big inroads into asset-gathering at the expense of mutual funds, threaten Wall Street's profits, change the financial advisory business, or be likened to encroaching Marxism. Yet all of that has happened, arguably since just 2008.

Now, after what seems like a decade of breakneck growth, the industry is at a turning point. Net new ETF assets in the U.S. jumped, on average, by 15% annually over the past seven years. But this year, through August, they were down 9%, according to the ETFGI research firm.

The slowdown is in part due to global trends, says Deborah Fuhr, ETFGI's co-founder. "Investors outside the U.S. have migrated to using products domiciled in their home countries or those in Europe because, in many cases, those products are more tax-efficient for them. But ETFs are doing better, relative to other products, so I don't view flows as plateauing."

Successful ETF launches are fewer and further between, and the industry has become incredibly concentrated, with more than 80% of assets in just three firms: Vanguard Group, BlackRock (BLK), and State Street (STT), home of the behemoth that got the ball rolling, the $280 billion SPDR S&P 500 ETF Trust (SPY). That leaves an awful lot of players hungering for a slice of what the industry expects to be a staggeringly big pie in the next five years.

So how does the now $3.6 trillion ETF industry take on the $16 trillion mutual fund industry? By starting to look more like it. Investors should brace themselves for an onslaught of new "index" products—such as smart beta, thematic, and bond ETFs, plus asset-allocation models using these funds—that look remarkably like actively managed funds and charge like them.

Issuers are elbowing one another to attract ETF assets, spurred by increasingly aggressive estimates of just how large this part of the investment world could become. Jim Ross, chairman of State Street's SPDR global business, says $25 trillion in seven years. Matteo Andreetto, former head of German index provider Stoxx and now SSGA's EMEA ETF head, says: "I'm very comfortable with $15 trillion in five."

That would be great—for the industry. Investors, however, should always be wary of the Next Big Thing. While ETFs have embraced marketing in a way most asset managers have not—quirky actress Elizabeth Banks now stars in commercials for State Street ETFs—not every new product deserves the spotlight or a spot in your portfolio. So, it pays to cautiously analyze the biggest trends:

Smart Beta: Also known as strategic beta, this umbrella term encompasses all manner of indexing other than capitalization-weighted. That could be simple, such as equal-weighting the stocks in a familiar index, such as the S&P 500 (.SPX). Or it could be as complicated as selecting and weighting stocks, based on factors including volatility, momentum, and likely dividend growth.

Smart-beta funds are hybrids: The strategy they use to select and weight stocks is an active one, while the buying and selling of shares are done in a somewhat passive manner, governed by certain metrics. For example, changes in holdings changes might be made only on specific days reserved for portfolio rebalancing.

In a July report, Boston Consulting Group called smart beta "the hidden threat" to active management. "The thesis is essentially a style bias that can be replicated quantitatively for a fraction of the price. Why would anyone pay a person when it can be done systematically for less?" says Brent Beardsley, who co-authored the report. Nonetheless, the funds have proved attractive; their assets have risen 30% annually since 2012.

Why some funds do better than others isn't always clear. Since its inception three years ago, the multifactor Goldman Sachs ActiveBeta U.S. Large Cap Equity (GSLC) has accumulated $4 billion in assets. It's priced competitively, at 0.09% of assets, but its portfolio makeup is very similar to the S&P 500. And investors have eschewed similar multifactor ETFs from BlackRock, State Street, and others, forcing dozens to close. Vanguard's factor suite of six ETFs and one mutual fund exemplifies the struggles of some factor products. Launched in February, the group has gathered just $140 million, with much of that in just one ETF, Vanguard U.S. Multifactor (VFMF).

Fixed Income: Here's where smart beta and factor investing make the most sense. When bond indexes are weighted according to market value, the biggest issuers of debt make up the largest portion of the index—not always what you want as an investor.

In addition, a popular benchmark for bond ETFs is the Bloomberg Barclays US Aggregate Bond index, a medium-term performance gauge that doesn't include high-yield bonds or much foreign debt.

Active managers have had a relatively easy time beating the index, which some fixed-income investors don't consider very good. Some 70% of actively managed intermediate-term funds beat their passively managed peers over the past year through June, according to Morningstar's latest Active/Passive Barometer.

Steve Laipply, head of iShares U.S. fixed-income strategy, says active bond investors contend that they follow approaches that can deliver outperformance. But, in his view, these "ultimately turn out to be factors that can be isolated and delivered in a fund at a much lower cost."

Thus, there's a lot of opportunity here for smart-beta ETFs, especially because, unlike equity ETFs, their market isn't nearly as saturated. There are more than 1,400 stock ETFs, but less than 400 bond ETFs. Plus, there's pent-up demand from institutions, such as insurers, which are projected to throw $300 billion into fixed-income ETFs in the next five years, according to BlackRock.

However, unless it's customized further, factor investing might not be the silver bullet the industry hopes it will be. Says Johns Swolfs, CEO of InsideETFs, a conference organizer: "Institutions want more nuanced and tailored ETFs. They want a more complete set of products—including high-yield and more corporates."

Even if bond investors forgo ETFs and stick with mutual funds, they'll probably own bond ETFs indirectly, as more active bond managers use them in portfolios. "We're seeing…greater adoption by active managers who have been hesitant to use these in the past," says Bill Ahmuty, head of SPDR fixed income.

Thematic ETFs: Funds focused on very thin market segments—cybersecurity, marijuana legalization, artificial intelligence—often are more sizzle than steak. Some charge high fees, offer poor performance, and have a short shelf life. Just ask investors in a whiskey ETF, for which last call sounded in June—just about 1½ years after its launch. That fund's purveyor, ETF Managers Group, also retrofitted a Latin America real estate ETF last year, shifting its holdings from real estate investment trusts to cannabis stocks, to capitalize on the legal marijuana trend. The fund, ETFMG Alternative Harvest (MJ), quickly became the world's largest pot ETF, reaching nearly $1 billion. But until late September, it didn't own Tilray (TLRY), one of the world's largest cannabis stocks. By the time Tilray joined the portfolio, it had rocketed to $300 from the mid-$20s in July, bringing new meaning to the term "buying high."

ETFs to diversify your portfolio

These ETFs span a focused range of equities, fixed income, and assets.

More thematic ETFs are coming. Goldman Sachs recently asked regulators for permission to launch five, including one for "human evolution" and the "New Age consumer." Does your portfolio need these? Probably not.

Ultimately, the next wave of growth will depend as much on marketing as on the nature of the products themselves. Model portfolios and digital platforms, online or smartphone apps, will drive sales. Technology made ETFs possible, and now it is making them easier to package into semi-customizable asset-allocation plans. Even financial advisors are increasingly using these pre-made models.

"This is a shift in control and power," says Ed McRedmond, founder of etf Ed Advisory, a consulting firm. "It's no longer like the good old days where you go out and sell a product to someone. Now it's about being in front of home offices and research analysts to land on a list of approved products."

Much like Nike steam-fitting a shoe to a customer's foot, big firms can create portfolios that fit into the investment framework—growth, value, momentum, or whatever—favored by a particular individual or institution. "What is increasingly driving new-product development is built for plug-and-play models," says Ben Johnson, director of global ETF research at Morningstar. Schwab 's brokerage platform and its masses of advisors, for instance, helped rocket it into the ranks of the top five ETF providers in just a few years, jumping ahead of early adopters, such as WisdomTree (WETF) and First Trust.

That's not stopping latecomers like JPMorgan Chase (JPM) from joining the party. The big bank's lineup of country-focused ETFs has gathered billions in assets since their inception in June.

The JPMorgan BetaBuilder Japan ETF (BBJP), for example, drew $1 billion in assets in its first week, making it the second-fastest growing ETF in history behind the $28 billion SPDR Gold Shares (GLD). Meanwhile, iShares MSCI Japan (EWJ) saw outflows of a similar scale. Given that JPMorgan had been one of that ETF's biggest holders, did the giant bank merely shift money from a rival's fund into its own?

JPMorgan's head of ETF distribution, Jillian DelSignore, says the bank has been "strategic" about ETF launches, but hasn't targeted any specific customers. "Our success really shows that we've been spending time with customers to understand their needs," she adds.

Says Matt Hougan, chairman of Inside ETFs and global head of research at Bitwise Asset Management: "I suspect that distribution-driven firms will steal a larger economic share of the ETF industry. That means the wirehouses monetizing their base will provide that next wave of growth."

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