Opportunities in ETFs’ next phase of growth and innovation

07 Aug 2013

As ETFs mark the 20th anniversary of their 1993 invention, their growth story appears to be only beginning. Greater investor appreciation of their simplicity and cost effectiveness, as well as expanding global markets and distribution channels, is fuelling further demand for ETFs. Opportunities are also emerging for new ETF sponsors to break into the market by creating innovative products.

In their first two decades, ETFs’ low costs, transparency and tax advantages set the stage for rapid expansion.[1]  A small group of ETF providers has come to dominate the ETF marketplace, particularly in the more mature US market. Exploiting first-mover advantage, they planted their ETF flags on most of the world’s major financial market indices, making it challenging for others to compete.

But the quickening ETF evolution is opening up the market – especially for the innovative and those with strong brands and distribution channels. The first half of 2013 illustrates both the market’s growth and its potential for new ETF managers. Globally, ETFs attracted $96.3bn, down slightly from the record $105.5bn in the same period of 2012 following June’s market volatility,[2] but nonetheless a substantial total. Four of the 2013 first-half’s top ten fund raisings were linked to Chinese indices – and managed by Chinese asset managers, not the big international ETF providers.

Changing Catalysts for Growth

A major factor in the growth of ETFs is the fundamental shift in investing practice by retail investors and their advisers. While retail investors were historically ‘sold’ funds, since the financial crisis of 2008 they’ve started to ‘buy’ funds.  Not only have investors themselves taken a more discriminating view of funds’ relative merits, but also their financial advisers have done so, encouraged by regulation in some countries. This trend is boosting ETF sales, as they generally have cost, flexibility and tax advantages when compared to other investment products.

In the US, registered investment advisers are using ETFs as asset allocation tools for their retail clients, seeking to create alpha at the client portfolio level, for which they charge an asset-based fee. They plan to significantly increase their use of ETFs by the end of 2013, according to a 2013 Greenwich Associates report.[3] This evolving use of ETFs is creating opportunities for new products, such as ‘smart beta’ offerings with exposure to factors such as demographic trends or specific sectors, and actively-managed products which are gaining some traction.

Elsewhere in the world, regulations in a number of countries are reinforcing the move towards ETFs by banning financial advisers’ sales commissions and increasing transparency requirements over costs, investment strategies, risks, etc. Australia and the UK have banned sales commissions, while the Dutch, Swedish and Swiss governments plan to do so, and Germany is mulling it over. The EU’s MiFID II directive may impose similar measures. This suggests there’s substantial room for growth in the retail market as financial advisers plan to increase their ETF investments.

Institutional investors such as pension funds and endowments have also been increasing their appetite for ETFs, using them to solve a variety of investment challenges. While they’re deploying ETFs for tactical purposes based on accessing liquidity, they’re also investing for strategic purposes, such as gaining long-term exposure to desired asset classes.[4]

In the Asia Pacific region, ETFs are growing especially fast. In 2001, there were just 10 funds with $12bn of assets, but by April 2013 there were 579 funds with $150bn.[5]  Money has been flowing into both equity index products and fixed-income ETFs in this region.

In Asia’s retail markets, initiatives to encourage savings are likely to boost ETF sales. For example, Hong Kong’s pension market regulator has expressed a desire to see more savings invested in passive investment vehicles, while Japan has introduced a tax-free savings scheme, inspired by the UK model.

Three Ways to Compete

We believe that the key to breaking into this fast-growing ETF market lies in having the right strategy in three areas:

  • Innovation: As the underlying ETF investor base evolves, investors will buy innovative products that cater to their specific needs. For example, there was a recent announcement about plans to develop an ETF that could be settled across Europe – rather than only on a national basis – which could simplify trade processing and settlement.[6] But other innovations may focus on new investment niches, such as ‘smart beta’ investment styles for financial advisers to use as tools in portfolio construction.
  • Education: Large numbers of investors are still unfamiliar with the concept of ETFs. Retail investors, their financial advisers and many institutional investors will need to be further educated about the advantages of ETFs and how to use them. Education has a particularly important role to play in less mature investment markets such as Brazil, China and India.
  • Geographical presence: Being a local player gives ETF managers an advantage in terms of brand strength. Additionally, in some fast-growing emerging markets, local banks control retail distribution. International managers aiming to enter these markets should consider possible joint ventures with local financial services companies with established brands and distribution channels.

Conclusion

As the ETF market continues to evolve, new types of ETF offerings and new ETF sponsors will emerge. The successful ETF sponsors will be those that develop ETF products which meet investors’ changing behaviours and needs. Additionally, these ETF sponsors will need to continue to focus on ways to leverage technology and develop sustainable processes and cost efficiencies, while complying with local, regional and global regulations.

With global assets of $2.04tn at the end of June 2013,[7] ETF sponsors have their sights set on continued significant global growth. But it’s likely that the next period of growth will involve a far greater range of products, geographies and investors. And this broadening of the ETF universe will create room for more sponsors to break into the market.



[1] BlackRock, ETP Landscape, June 30, 2013.

[2] BlackRock, ETP Landscape, June 30, 2013.

[3] Greenwich Report: US Exchange-Traded Funds, Q2 2013.

[4] Greenwich Report: Institutions Embracing ETFs to Help Solve Investment Challenges, May 2013.

[5] BlackRock, ETP Landscape, April 30, 2013.

[6] Euroclear press release, June 04, 2013.

[7] BlackRock, ETP Landscape, June 30, 2013.