Where ETFs are headed in 2019

A race to the bottom in fees should continue, and expect to see more funds close up shop.

  • By Ari I. Weinberg,
  • The Wall Street Journal
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Despite all the bouts of volatility in stocks and bonds, the rush of assets into exchange-traded funds continued apace in 2018. Net flows for U.S. ETFs totaled $295 billion; $197 billion went to stock funds and $99 billion to fixed-income funds, while $1 billion came out of commodity, currency and real-estate funds.

Total U.S. ETF assets under management closed 2018 at roughly $3.4 trillion, according to research firm XTF. That is still well below the $18.7 trillion or so in mutual funds—the older cousins of ETFs—but it is massive nonetheless.

While the torrid pace of new product launches continued, it was a washout year for exchange-traded notes—debt securities that track indexes and trade similarly to stocks. Issuers launched 269 new products and closed 151. In April, investment bank Barclays (BCS) closed 50 ETNs, 16 of which had been replaced earlier in the year.

Competition remained fierce among providers of exchange-traded products as Vanguard Group dropped commissions for most ETFs on its brokerage platform—and the prospect of a 0% expense ratio for ETFs looms large. Fidelity Investments launched a handful of no-fee index mutual funds last August.

ETF assets at JPMorgan Chase & Co.’s (JPM) J.P. Morgan Investment Management surged to nearly $20 billion, thanks to $15 billion of net flows to its ultrashort fixed-income offering and several low-cost international index funds. But that is still a far cry from the exchange-traded assets at BlackRock (BLK) , with $1.3 trillion, and Vanguard, with $856 billion.

Here are five trends to watch in 2019.

• One rule to rule them all. ETF issuers will be on the lookout for the release of a final new ETF rule from the Securities and Exchange Commission. Proposed last summer after several false starts over the years, the rule attempts to “level the playing field,” says Dave Nadig, managing director of ETF.com, a unit of Cboe Global Holdings. “It’s a good cleanup for the industry,” he adds. The rule, which Mr. Nadig expects will ultimately have little visible impact on investors, would clear the way for more issuers to create or redeem ETF shares in so-called custom baskets which can help improve the efficiency and trading for an ETF, particularly when there are changes in an index. Under the current systems, whereby ETFs and asset managers are operating under specific relief from the Investment Company Act of 1940, some managers have more discretion than others regarding how the baskets of holdings used to create and redeem index-tracking funds are built. Some are required to fully replicate the ETF; others have more discretion when needed.

• Approaching the asymptote. The race to the bottom in fees on individual ETF offerings will continue as the largest issuers and asset managers, particularly those with significant brokerage, advisory, risk-management and custody businesses, push on their ability to “find revenue other ways,” says Robert Tull, president of Procure Holdings. “The economies of scale are massive.” In fact, 72% of the assets in ETFs are held by funds with expense ratios below 0.20%, capturing 95% of net flows in 2018, according to XTF. While competition has been fierce for U.S. equity offerings, the fee war has spread to international and fixed-income funds, as well as specialty products such as gold funds and those targeting investments on environmental, social and governance (ESG) factors. Moreover, the pressure to cut advisory fees could re-emerge with more investors evaluating robo advisers or similar low-cost services at the major brokerage firms as well as all-in-one products like the recently launched Trinity ETF from Cambria Investments (TRTY), says ETF.com’s Mr. Nadig. BlackRock also offers a suite of funds with investment allocations that match varying levels of risk. These funds were launched in the depths of the financial crisis and have attracted more interest (and assets) in the past several months.

• Stuck in the doldrums. For most investors, the benefits of ETFs lie in the transparency of the offering and the ability to buy or sell as needed during market hours. But with the flood of new products, and less institutional support, more funds are wallowing with low assets, according to Elisabeth Kashner, director of ETF research at FactSet. Of ETFs launched from 2007 to 2016, 45% of funds that failed to reach $50 million in assets by the end of their first year on the market have since closed, and 30% are still below $50 million in assets. While institutional investors have more leverage to trade in and out of smaller funds, individual investors and advisers will often find less liquidity and higher trading spreads in smaller products.

• A re-evaluation of factors and fundamentals. Last fall marked the first true bout of volatility and drawdowns for most so-called smart-beta ETFs—index funds that focus on stock attributes such as dividends, price momentum, value and size—the bulk of which were launched since 2010. This year could be a reckoning for more marginal products, such as sector and geography factor funds as well as multifactor products that “a lot of investors don’t understand very well,” says Jeff Tornehoj, director of fund insights for Broadridge Financial in Denver. He expects that investors big and small “will continue to be cautious and deliberate in their uptake,” especially as a lower-cost replacement for actively managed equity mutual funds, which saw $182 billion in withdrawals for the one-year period ended in November 2018, according to Morningstar, compared with $76 billion in net new assets for alternatively weighted equity ETFs, according to XTF. (Moreover, actively managed ETFs saw $26 billion in new flows, mostly to short-term fixed-income ETFs used as money-market replacements.)

• More closures, healthier issuers. “Competing with BlackRock and Vanguard for core products will get even more challenging, but there is significant room to differentiate with alternative offerings,” says Daniil Shapiro, associate director of product development for Cerulli Associates. “The pace of issuance or closures is not a barometer of the health of the business.” Mr. Shapiro sees differentiated products from smaller asset managers such as VanEck and WisdomTree, insurance providers such as John Hancock, and advisory firms, taking hold as ETF assets under management march toward $17 trillion by 2030. Look for more self-indexing, whereby an issuer is able to trim the cost of licensing an index from S&P Dow Jones Indices, MSCI or FTSE Russell, by building customized investments for institutional investors.

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