The Second Act Begins for ETFs
Asset managers have reason to be excited by the growth prospects for ETFs, according to a major report by management and strategy consultants McKinsey & Company.
Based on current projections, total global ETF AUM could grow from approximately $1.5 trillion today to between $3.1 trillion and $4.7 trillion in the next five years, according to management consulting firm McKinsey & Company.
In their report, entitled ‘The Second Act Begins for ETFs – A Disruptive Investment Vehicle Vies for Center Stage in Asset Management’, McKinsey say that since 1995, US ETFs have generated consistently positive annual net flows through both up and down market cycles:
“Between 2000 and 2010, exchange traded products (ETP) assets under management (AUM) grew over 30% per year. To put this in context, consider that conventional US mutual funds grew on average 5% to 6% annually over the same time frame. In fact, in the last decade, no other significant segment of the US asset management industry has grown as quickly and consistently as ETFs.”
The report shows that global trends have been equally impressive and that the global outlook remains strong:
“Between 2008 and 2010, European ETF markets grew at rates comparable to those in the US, while Asia-Pacific (excluding Japan) ETF markets grew by more than 100%, albeit off much smaller asset bases. The outlook for global ETF markets remains strong, with growth rates expected to rival or even surpass the US in the years ahead. Based on current projections, total global ETF AUM could grow from approximately $1.5 trillion today to between $3.1 trillion and $4.7 trillion over the next five years.”
The report details how ETFs are disrupting the asset management industry across multiple dimensions by expanding investor access, democratising access to an array of asset classes and strategies; by allowing advisers to monetise advice, changing the way retail advisers work with clients, replacing the stock-picking adviser of the past with the ETF asset allocator of today; and through superior product design, with ETFs offering a stronger overall value proposition than traditional passive mutual funds.
Industry growth
While there may be bumps in the road, McKinsey believe the outlook for global ETF growth remains strong and global AUM could more than triple in the next five years. The report points to five trends that will support this growth:
i) Renewed focus on investment cost. ETFs benefit from a growing focus on investment costs. Poor fund returns in recent years have prompted investors and advisers alike to question the benefit of active management versus cheaper passive products (a large fraction of which are ETFs).
ii) Fee-based advisory growth. A trend toward fee-based advisory models, where advisers are compensated on total assets under management as opposed to commission, is also aligning clients’ and advisers’ focus on low-cost products such as ETFs.
iii) Regulatory emphasis on transparency. All indicators suggest that regulators will continue to demand greater disclosure from all asset managers, especially in matters of pricing. As ETFs offer comparatively simple pricing structures compared to many other asset management products, they should have an advantage over traditional funds in an era of greater transparency.
iv) Rising investor awareness. ETFs have delivered impressive growth despite still relatively low awareness and adoption among investors, advisers and institutions – implying that significant growth potential remains.
v) Increased institutional appetite. While hedge funds and money managers have been focused on ETFs for some time, other institutions such as defined benefit (DB) and defined contribution (DC) plan sponsors, endowments and foundations are just starting to show meaningful interest.
Active ETFs could change the plot
The report says that, while active ETFs are a nascent product category representing approximately 1% of all ETF assets today, they have the potential to change the narrative in traditional asset management and initiate a new growth curve for the industry as a whole.
“Many traditional asset managers are aware of the disruptive risk that active ETFs could pose. Indeed, sponsors have filed more than 800 applications for new active funds with the SEC. Many are from traditional managers without ETF products who are simply preserving their options in case the market expands.”
The report outlines a number of industry trends that are increasingly favourable for growth in active ETFs. In particular, it highlights four conditions that could spur rapid growth acceleration:
i) Standardised approach. Building an active ETF is far from straightforward. Solutions range from pooling multiple ETFs together for creation and redemption orders (thereby masking individual ETF holdings) to “black box” encryption that uses factor-based models to identify proxy securities baskets. Regulators have yet to signal willingness to endorse a method.
ii) Track records. The first active ETFs qualify for Morningstar ratings this year as they complete a three-year track record. As more active ETFs reach this milestone, it should increase their visibility with advisers and retail investors and spur adoption, assuming that investment performance is satisfactory.
iii) Big brand participation. As widely recognised and respected brand name managers make moves into the active ETF domain, their endorsement will increase the credibility of active ETFs and accelerate demand and adoption.
iv) Clarity on fund conversions. While the SEC’s hold on exemptive relief requests has slowed the formation of new active funds, resolution is likely in the short to medium term.
McKinsey reckon that, if active ETFs do take hold, they will start from the fixed-income side of the market as fixed-income funds are less vulnerable to front-running and therefore face less transparency risk. One segment of traditional fixed income funds that may be particularly exposed to active ETFs in the near term is the $3 trillion money market fund business.
Please visit the McKinsey & Company website for further details: The Second Act Begins for ETFs