ETFs: Priming the $5 Trillion Pump

Exchange-traded funds, or ETFs, are, to quote Derek Zoolander from the eponymous film, so hot right now. Something is definitely happening in this space, and it mirrors a wider shift in general investor behavior.

The reasons behind this are complex, including the relative simplicity of trading ETFs and the fee structure associated with them, as well as a desire for diversification in buy-side portfolios. But there’s more.

“I think we’ve seen active managers on the back foot over the last few years because of industrywide outflows from their products into passive vehicles and ETFs,” says Mark Fitzgerald, head of ETF product management, Europe at Vanguard.

Put simply, the growth of ETFs looks like it isn’t going to run out of road any time soon, and that’s thanks in large part to technology’s influence over future generations of investors. Accessibility, user friendliness, cost and transparency are the key words for modern investors, and technologically suitable investments such as ETFs hit a sweet spot that traditional instruments struggle to find.

“It’s tough to deny the efficiency of technology,” says Steve Sachs, managing director and head of capital markets at Goldman Sachs Asset Management (GSAM). “Particularly as you know how certain generations—Millennials being a great example—love to interact with that type of technology for all aspects of their life, and financial services won’t be any different.”

The New Age Investor 

Twenty-five years on from the first-ever US listing of an ETF, the passive product has grown staggeringly over the years, taking huge strides in the last decade. Globally, ETFs are now listed on 68 exchanges and across 56 countries worldwide and are expected to soar past $5 trillion in assets under management (AUM) this year. 

In 2017, the instruments—which provide exposure for investors by tracking indices, bonds, or a basket of assets without the need for direct ownership—grew by $1 trillion in 2017, or 25 percent in terms of assets under management. Inflows into ETFs reached over $460 billion, shattering the previous year’s record of $288 billion, according to data from State Street Global Advisors.

Some of the core drivers of growth over the years have emerged from a newfound awareness of the modern-day investor, relating to costs, asset allocation and alpha generation. Now, as younger investors are making more sophisticated portfolio decisions, appetites appear to be growing for products that allow for greater exposure to wide-ranging securities, guaranteeing profitable returns in a fraction of the time—in other words, fast, easy money. 

According to a survey conducted by US bank and brokerage firm Charles Schwab, 91 percent of Millennial investors would select ETFs as their investment vehicle of choice and 80 percent would see it as their primary investment vehicle in the future.

“What we are seeing is many investors rationalizing where they can generate alpha themselves either through picking securities or buying active funds, or where they can’t, they are increasingly using ETFs to generate alpha through getting the asset allocation right,” says Deborah Fuhr, managing partner and co-founder at ETFGI, an independent research and consultancy firm. “Because asset allocation delivers about 90 percent of the variation of the returns you’re going to achieve and that’s something more investors are likely to get right.”

Unlike mutual funds, ETFs are listed products, meaning they can be traded on a stock exchange during trading hours. This enables investors to have access to thousands of securities at any one point through a single transaction. Vanguard’s Fitzgerald explains that new waves of investors are drawn to ETFs as they offer a level of exposure and efficiency that traditional products and asset managers are unable to replicate. 

“So an institution, for example, might spend several hundred million dollars, euros or pounds on a given exposure, whereas individual retail investors could buy that same product and invest maybe a few hundred,” he adds. “And here’s the key thing: They pay the same amount, and that is very unusual.”

With wised-up investors honing in on price and performance, it’s difficult to deny the visible shift from active portfolio managers, who are paid large fees to outperform the market, into passive instruments such as ETFs, which are purchased to track an index at fraction of the cost. The past several years has seen the flight to passive intensify, enriching the likes of ETF heavyweights such as BlackRock and Vanguard, and dragging the spotlight away from active portfolio managers. 

“They’re going to have to try to be better at outperforming and I suspect many of them will not persist into the future, because now the cat’s out of the bag around costs,” says Fitzgerald. “These types of conversations are taking place every day and I don’t think people are going to wake up and forget the power of cost, transparency and understanding what you’re buying.” 

But cost alone is not the only driver for modern investors. Transparency has claimed a front seat in recent months because regulatory steps taken in Europe. The revised Markets in Financial Instruments Directive (Mifid II), which came into effect on January 3, has been a champion for transparent pricing products and the disclosure of investor costs. In other words, the regulatory pendulum appears to be swinging in favor of products such as ETFs. Although the effects of regulations have yet to fully bed in, some say the latest shift has already nudged ETFs to the front of the queue for professionals seeking to make hassle-free investments. 

“I would argue most regulation is favorable to ETFs because they are broadly distributed products. So anything that lowers the barriers to broader dissemination of information—when you use Mifid II to standardize how information can be disseminated and through what mechanism—actually makes it easier for someone who is trying to scale their business life,” says Michael John Lytle, CEO of Tabula Investment Management. 

Additionally, on the US front, the ETF industry has been given a green light in terms of relaxing of rules surrounding the approval of ETF products. In late June this year, the US Securities and Exchange Commission (SEC) voted to propose modernization of the regulatory framework around ETFs, which currently obliges creators of a new product to apply for an exemptive order under the Investment Company Act of 1940. GSAM’s Sachs says the proposed ruling will help create a level the playing field for ETF providers in the US and enable a clearer understanding of the nuances between ETF and other traditional products. 

“Broadly speaking it does help to turn a quilt into a blanket,” he explains. “Before it was this patchwork of all these rules, regulations and interpretations, and [now] this will help turn it into a cohesive framework for ETFs. It doesn’t answer all the questions but it certainly is going to clarify a lot of things that has always be a bit of an issue for ETF issuers.”

But new-age investors are not alone in their quest for quick, cheap and hassle free investments. Over the years developments in technology have been made to modernize the ETF space and drive this product into the 21st century.

Digital Advisors 

With the newest generation of investors entering the fray, robotic advisors have been touted as one of the core reasons for growth in the ETF industry over the last decade. Following years of development, research has shown that Millennial investors have been keen to adopt automated advisory services to build portfolios and make important investment decisions. Using data and algorithms, the robo-advisors manage and fill portfolios, commonly using low-cost, low-risk products such as ETFs. 

GSAM’s Sachs explains that as far as technology advancements go, robo-advisors have played a key role in the uptake of ETF investments. He highlights that “current market conditions” coupled with “demographic trends” of new investors have been significant drivers in its success in recent years. 

Since the advent of robo-advisors in 2008, following the financial crisis, demand for cheaper alternative to traditional advisors has grown steadily over the years. According to Statista.com, digital advisors currently have $1.5 trillion in assets under management and are projected to reach a massive $4 trillion by 2019, doubling that again by 2020. 

ETFGI’s Fuhr further explains that investors are using robo-advisors on a regular basis to make better informed investment decisions tailored to their circumstances. The robotic platforms operate by processing vast amounts of data—often too difficult for a human to consume—to provide in-depth market knowledge and portfolio options.  

“So they go to a robo to think about asset allocation and what kind of products they buy,” she adds. “They may not give their money to the robo, but now they’re in empowered to have conversations with someone about how and where they might invest and often they will use ETFs.” 

In a bid to modernize ETFs and streamline trading processes and practices, providers have also taken significant steps to update their technology to digital and automated systems. Struggling to keep up with the growth of the ETF space over the years, investment firms are only just getting around to upgrading their systems and transferring their data to modern technologies—to date, they have often relied on emails and Microsoft Excel spreadsheets. 

Gavin Nangle, head of asset manager solutions at State Street Global Advisors, explains that the bank is currently in the process of automating its ETF technology across the wider business in an effort to improve efficiency and enhance transparency between issuers and investors. He says the firm is also developing an ETF portal that will enable investors to access their data through a State Street platform. 

“The ETF products and our efforts toward digitization, automation, and provision of increased real-time transparency into the calculation process, the interaction with investors, and interaction with the community—all of that stuff is hugely important for what we’re doing overall,” he says. 

But now, as asset management firms are just coming to grips with modern technologies and upgrading their systems, the onset of emerging technologies and the appetite for alternative products are flickering on the horizon. 

New Tech Era

As dollars pour into ETFs at a furious pace, buy-side firms are fully aware of the opportunities that emerging technologies can offer. Smart algorithms and artificial intelligence (AI) have been widely deployed in multiple areas across firms to facilitate trading analytics, surveillance and regulatory compliance, to name a few areas. Industry experts believe that technologies such as machine learning can be used process vast amounts of ETF data and apply it to tasks such as trading analysis, asset allocation, the creation of indices and tracking securities. 

Tabula’s Lytle says AI technology works best in areas of the market that are already rich in robust data. One example is the equities market, where vast amounts of data on the underlying securities being traded are widely available on exchanges such as the New York Stock Exchange or Nasdaq, as opposed to less-liquid markets where patchy data and gaps in analysis are more likely to occur.

“The idea with AI is that you can actually give enough information to a machine so it can make a decision, and it can make a better decision perhaps eventually than a human being can,” he adds “It is a tip-of-the-iceberg sort of thing; it’s only possible in the most data-heavy environments.”

Other emerging technologies which have dominated the industry’s attention over recent years include blockchain or distributed-ledger technology (DLT). In the US, heavyweight investment firms such as Vanguard are currently experimenting with the use of blockchain to transmit accurate index data. Still in its nascent stages, the technology could be developed to create a global network connecting thousands of constituents and recording multiple calculations. 

“Imagine all the calculations for all the characteristics of each of those constituents for that one benchmark and then imagine you’ve got lots of benchmarks in trying to transmit this data accurately, says Vanguard’s Fitzgerald. “Blockchain could be very interesting for making that process hyper-accurate. So that’s an interesting story developing—early stages, but that’s out there.”

In recent weeks, the prospect of a new type of ETF product has ruffled feathers across the industry. In late June, VanEck teamed up with SolidX to file their third bid with the SEC to list a bitcoin ETF on Cboe’s BZE exchange, dividing opinions on whether the industry was ready for a new wave of digital products. 

 “I don’t think from a regulatory perspective they have their heads wrapped around it enough,” says GSAM’s Sachs. “I think questions still remain in the crypto space in general.” 

The primary concerns surrounding an ETF product involve areas such as liquidity, price valuation and customer protection. The SEC is expected to take eight months to decide its verdict on the latest application to allow for a thorough assessment. 

“It’s going to be pretty tough for me to buy a crypto ETF if I know that a certain amount of the value could possibly vaporize overnight due to theft, because that’s not a problem that I have to think about as it relates to holding stocks, bonds, commodities or things of that nature,” Sachs says.

(For an in-depth look at VanEck’s efforts to kick-start cryptocurrency ETFs, see page 32.)

What’s on the Horizon?

Now, as modern investor appetites, regulatory shifts, and technology advancements pave the way for further growth in the ETF space, some questions still remain unanswered. One concern relates to the flood to passive investments and the possibility of creating a bubble. As ETFs cover multiple securities it is yet to be seen how this may impact the wider market and regulators are keeping a watchful eye on the activity. 

One of the most common perspectives from market participants is that education is key to trading ETFs and understanding its impact on the wider market. 

“For many it’s about becoming educated,” say ETFGI’s Fuhr. “With ETFs you have to learn about how when and where to trade them. I think that’s an added thing—because there are so many different product benchmarks to understand. So I think you need to do your homework, you need to come up with a due diligence framework to compare and select ETFs just like you would compare in selecting a mutual fund.”

As for whether some of the wilder predictions in the market, such as ETFs reaching an AUM of $20 trillion in the next few years, come to pass, time will tell. But with the confluence of investor appetite and technology, they’re clearly well on their way.