Financial Services Ireland

Passive funds on track to exceed active funds by 2027

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Exchange Traded Funds are uniquely placed to benefit from the shift to passive and will reach $7.6t globally by the end of 2020, according to EY’s Global ETF Report 2017: Reshaping around the investor. This growth will be underpinned by growing knowledge of ETFs and their uses, adoption by a widening investor base and these funds’ key attributes of low cost, transparency and liquidity.

As the industry grows in size and influence, the competition to attract inflows will heat up, and more promoters will enter the market. The report focuses on the importance of getting the investor experience right in order to capitalize on the industry’s huge potential. For ETF promoters looking for sustained success, this means, refining investor journeys, reducing investor costs and maintaining product quality in the face of regulatory change.

Market trends are extremely favourable for the growth of the ETF industry; from the increasing allocations to self-directed retirement saving, to a broader shift into passive investments, we have now reached a critical point of development.

How investors use ETFs

The ETF market will be transformed by both current and new investors. The survey suggests that 15 to 25% of ETF inflows over the next three years will come from new investors. Investors typically first turn to ETFs for selected exposures they cannot access elsewhere, but then become more comfortable using them as the building blocks of portfolio construction, for liquidity management and for factor based investing.

Institutional investors, who will continue to dominate ETF inflows, use them for a variety of different purposes. Pension funds will use ETFs for liquidity management while wealth managers will look for core exposure through active portfolios. Certain hedge funds will use leveraged and inverse ETFs to execute high-conviction long or short positions.

The ETF industry needs to do more to understand and anticipate the long-term needs of different investment groups, addressing their concerns and developing teams that speak to their unique challenges.

Product innovation

The shift to passive will bring more and more assets into Exchange Traded Funds, and while the majority of inflows is likely to be captured by core passive products, smart beta products including single and multi-factor ETFs will also benefit. That means that the range of ETFs will continue to expand.

Fixed income products will drive growth over the medium term, growing to over $1.6 trillion by 2020, from $0.7 trillion today. These come from a lower base than equity ETF products, both in absolute terms and relative to the mutual fund industry and the wider fixed income markets.

Promoters will need to look to technological advances in constructing new products that meet investor needs, and this may enable ETFs to push further into the smart beta and active world. By 2020, we see the smart beta ETF world doubling in size, while the active ETF world will increase four-fold.

Innovations in product construction will take many forms, including exposure to a variety of themes and factors, greater access to high yield and emerging market debt, and using advances in AI to create new active investment strategies.

ETF providers will need to anticipate investor needs, incorporate larger trends in regulation and technology, take advantage of long-term opportunities and focus on educating investors.

Reducing Investor Costs

ETF fees continue to fall, reaching on average 27 basis points last year. While the report contends that “zero-fee” ETFs will not become the norm, 72% of people interviewed for the report expect fees to fall further. Pressure on fees will spread from traditional passive ETFs into smart beta products. Becoming a low-cost provider is a prerequisite to survival.

Beyond top-line fees, firms are future-proofing operating models by looking to reduce all costs of ownership. Nearly half of respondents (43%) feel there is insufficient competition between index providers. As a result, certain promoters have started to or are looking at the option to self-index. Propping up returns for ETFs through stock lending programs and focusing on best execution will also bring down the overall cost of ownership for investors.

Responding intelligently to regulation

Research respondents expect regulatory changes to change the way ETFs are distributed. ETFs should, in aggregate, benefit from regulatory changes, such as the Department of Labor Fiduciary Rule and MiFID II that promote the transparency that investors need. Regulatory focus on value for money also plays into the hands of ETFs, as a low cost product.

As the regulatory landscape continues to evolve, there is growing scrutiny of the industry’s potential contribution to systemic risk.  Awareness of how taxation can affect product performance is also growing. The industry feels that specific regulation may be positive for the industry, as an enhanced regulatory framework for ETFs would be positively viewed by investors.

The industry needs to develop a comprehensive view of regulatory threats and be willing to modify products that underperform as a result. A combination of local understanding and global insights can help investors understand the overall regulatory environment and how this will impact investor journeys.

This article was originally published in Finance Dublin in December 2017.




Kieran Daly

FS Partner, Assurance, Wealth and Asset Management
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