From Donald Trump’s tweets to trade disputes and tech stocks falling, 2018 has proved that volatility can become a constant. Yet exchange-traded funds (ETFs) have shown themselves resilient amid the uncertainty — and the ETF industry has seen what I’d call “normalized growth” in a volatile year. However, the way ETFs grew was very different from the previous year and our 2018 ETF research found that ETFs are indeed entering a new phase of growth.
EY analysis shows that ETF providers are now shifting their focus to strategies that center on enhancing distribution, accessing new markets and launching new products, particularly those with higher fees, such as active ETFs, thematic investing and smart beta.
In 2019, ETF providers are pursuing four pillars of profitability:
- Distribution enhancements
- Product innovation
- New markets
- Cost reduction
At EY, we believe that the fundamentals continue to be stacked in favor of the sector. With investors continuing to flock to the ETF industry, it has entered a new phase — and one that’s marked by continued growth, but also by the need to pursue process improvements, product innovations and new markets in an attempt to build differentiated market-places. This is because established ETF players are starting to prepare themselves for the expected inflow of new competitors into the market.
The ETF industry is confident that the double-digit growth we’ve seen will continue. More than half of survey respondents (56%) expect the growth rate of the ETF industry to be between 11% and 20% over the next three to five years. Nearly a quarter (22%) of respondents expect a growth rate of more than 20% compared with just 10% of respondents in 2017. And more than half (57%) of asset managers indicated that they expect the success ratio of new launches will improve in the future. This is up from 36% in 2016 and 45% in 2017.
New players are eager to grab a slice of the ETF pie
Inevitably, this expected growth is going to attract new players. We’ve seen this trend consistently year on year — and 2019 will be no exception, with 92% of respondents in agreement that more fund managers will attempt a foray into ETFs in the coming year.
Who will enter the market, though, is less clear — asset management arms of banks currently without ETFs are perceived as the most likely new entrants, closely followed by active managers looking to grab a slice of the passive investing pie. Overall, a diverse picture of the ETF challengers emerges:
- Asset management arms of large banks with no current ETF offering
- Active managers with no current ETF offering
- US ETF managers expanding into new regions
- Niche players
- Other ETF managers expanding into new regions
Clearly, the market trends, as well as the growth potential and the additional benefits that ETFs can offer to distribution, mean that new players will enter the market in 2019. Consequently, an ever-wider range of investors will be serviced with an ever-expanding range of products — we’ve counted more than 7,400 active products across 399 promoters and 76 new products in Europe in 2018, and there are ample opportunities for further new and innovative products in 2019.
Active ETFs resist fee pressure, but pose challenges
Active ETFs continue to grow, albeit from a low base. Nonetheless, active ETFs gathered over US$21b in 2018, adding to the US$24b gathered the previous year. That’s a continually increasing growth trajectory for active ETFs. As promoters look to new products that can help generate a higher fee income, active ETFs are an obvious place to start; the average fee rate for active ETFs is more than double the overall industry average globally. What’s more, our research suggests that pricing pressure will not be as strong on active ETFs as it has been on core passive products.
Therefore, it comes as no surprise that more than 90% of respondents see active managers entering the ETF space to create active ETFs over the next three years. Meanwhile, under 90% indicate that existing passive ETF promoters will enter the active ETF space over that same period.
Our overall analysis paints a picture of a confident industry — and this confidence comes through in the active ETFs arena as well, where around a third of respondents expect the compound annual growth rate in active ETFs to be 10% or more over the next three years across Europe, Asia and North America.
Yet this significant growth is subject to the ETF industry overcoming hurdles, some of which are substantial.
Portfolio transparency — striking the right balance
The transparency issue is the key point of contention for managers. They’re looking to get the balance right between protecting the investment manager’s investment strategy, and allowing the market to price and trade in an efficient manner. As a result, the number of active ETFs is limited — as are promoters’ growth plans — and products tend to focus on those asset classes that are hard for investors to replicate.
From our discussions, it appears that opinion is split over whom portfolio transparency should be given to, whether it’s to the full market or just to authorized participants. However, most of the respondents are of the opinion that daily transparency is required:
- Transparency should be provided daily or at multiple points throughout the day, say 80% of respondents, while 17% think it should be provided monthly or quarterly.
- Market makers should be given transparency daily or more frequently, according to 85% of respondents.
- Authorized participants should be given transparency daily or more frequently, in the opinion of 82% of respondents.
- Only 29% of respondents say all investors should be given transparency weekly or less frequently.
Regulation — is it helping or hindering growth?
There are certain regulatory developments that may help this growth — notably the feedback statement issued by the Central Bank of Ireland (CBI), where the CBI stated that they would not prohibit ETF share classes of mutual funds. This may ease the entry of active managers into active ETFs.
Overall, we believe that regulation could both help and hinder the growth of the ETF industry. While the CBI’s feedback statement, MiFID II and the focus on value for money by the UK Financial Conduct Authority (FCA) are all largely seen as positive developments, the International Organization of Securities Commissions (IOSCO), liquidity focus and Brexit are more likely to have a dampening effect on business.
As the industry continues to grow and evolve, it’s increasingly focusing on regulators — something it should see as a positive development. The industry can use this increased scrutiny from regulators to highlight the benefits of ETFs to the end investor. This is particularly true when we consider whether ETFs offer value for money.
In this regard, the UK FCA Asset Management Market Study (AMMS) is seen as positive news for ETFs, as they have a simple management fee structure without performance fees. They also clearly compare favorably with actively managed funds, which will find it more challenging to justify higher costs and charges. However, the ability to demonstrate investor value for money as outlined by the FCA is not just about price.
We expect promoters to look at factors that can be compared with ETFs in order to assess whether a product offers value for money. This would include identifying relevant products on the basis of style, strategy and size, and comparing management fees in the product, as well as trading costs within the portfolio. Promoters may also look at anti-dilution levies when comparing ETFs with similar mutual funds.
In fact, 69% of survey respondents say their value for money framework is progressing or has been completed, while only 14% do not have plans to introduce a framework. That leaves only a small minority of ETF players that are yet to start incorporating the value for money agenda into their ETF frameworks.
