The Inexorable Rise of the ETF

The rise of the exchange traded fund appears unstoppable. At the end of the first half of the year, according to industry research group ETFGI, ETFs (including exchange traded products) were worth $2.97 trillion globally – overtaking the value of the hedge fund market for the first time. By now, it is likely that the sector has broken through the $3 trillion mark, though we don’t yet have the data. Either way, these funds have collectively doubled in size over the past five years.

There are all sorts of reasons for this growth, but most recently it has been the failure of active managers to outperform in an extended bull market where asset prices have risen across the board courtesy of monetary authorities’ quantitative easing policies (albeit with ups and downs along the way). If asset managers can’t beat the market, investors understandably ask, “Why should we pay their higher fees?”

Index-tracking mutual funds offer low-cost passive investment too, but ETFs offer additional benefits. The stock market quote gives them transparency at any moment of the day, for example, and the low cost of setting up an ETF means that in most markets they’re able to undercut mutual funds.

These advantages have seen ETFs proliferate in variety as well as volume. While mutual funds have generally stuck to tracking equity indices, ETFs are now available that offer exposure to almost any asset class you care to mention – and often to underlying indices created specifically with an ETF in mind. Fixed income and commodity ETFs are commonplace, but the securities also give investors access to less liquid assets – including alternatives such as real estate and the hedge fund sector.
All these trends have brought ETFs full-circle. What began as a passive investment vehicle has become something quite different for many investors and advisers: a way to actively manage their portfolios at low cost. They provide an affordable way to achieve a given asset allocation – and a broader allocation – just as actively-managed funds once promised. You can see why many advisers are now opting for ETFs wholesale on behalf of clients – and the new breed of ‘robo-advisers’ likes them too.

Marketing ETFs

So far, so good. But that evolution has implications for the way in which ETFs are marketed to advisers and investors. These are no longer basic staples of investors’ portfolios that will be supplemented by more sophisticated products – the so-called core and satellite approach that was fashionable for a time – but represent the entirety of many investors’ holdings.

As such, investors want far greater transparency from ETF providers. They want to understand exactly what’s under the bonnet of each fund, where the risk exposures lie, how return has been achieved, what volatility has been – the list is almost endless.

Those demands are not unreasonable from investors depending on ETFs for the execution of their entire investment strategy. All the more, since tracking errors tend to rise on ETFs tracking than esoteric assets – as do charges (which in any case need to be unbundled from other costs of investment).

Leading ETF providers – the likes of BlackRock, Deutsche, State Street, Invesco and Vanguard – increasingly get this need and are stepping up their marketing activities accordingly. But all ETF providers must meet this challenge.

Where will the ETF’s ascendancy end? Well, mutual funds globally currently boast $15 trillion worth of assets across both active and passive strategies. That may be five times as much as the ETF sector, but the latter is catching up fast from a standing start. A more sophisticated approach to marketing will accelerate the speed at which ETFs close the gap.