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Next-Generation Growth Drivers

As impressive as the ETF industry’s growth has been over the past 14 years, many believe the industry is poised for even greater growth in the years to come. Barclays Global Investors expects ETF assets to top $1 trillion by 2009, and $2 trillion by 2011.

Achieving close to 300% cumulative growth over the next three years would be an impressive feat, but a number of factors are coming together to drive the market forward.
A Desire For Transparency

The financial crisis of 2008 presented clear evidence of the risk of inadequate transparency. Many mutual fund investors experienced this firsthand: Unable to see in real time what their fund managers were buying, many discovered too late that they were invested in risky firms like Lehman Brothers, AIG and Fannie Mae.

It’s not the first time that transparency has come to the fore. Each financial crisis over the past decade has driven a sharp uptick in ETF assets: the Internet bubble of the late 1990s, the mutual fund market-timing scandal of the early 2000s. Each time, investors seemed to realize that having full transparency into which stocks or bonds are held on their behalf is fundamental. The financial crisis of 2008 appears to be no different, and the most recent data on relative asset flows support this.

The 401(k) Market

Retirement investing remains the great unconquered frontier for ETFs. Heading into the third quarter of 2008, Americans held $4.3 trillion in employer sponsored defined contribution plans, with more than half of that being allocated to conventional mutual funds.  

ETFs currently make up only a tiny part of the 401(k) universe. There are various technological impediments that have prevented them from establishing a foothold, highlighted by the brokerage costs involved in purchasing a small number of shares on a regular basis. Further, many 401(k) programs are financed through fees unique to mutual funds: sub transfer-agency, and 12(b)1 marketing fees.

However, some ETF sponsors are making significant changes to their business in order to tap this tremendous pool of assets. WisdomTree, for example, has established its own dedicated 401(k) platform that circumvents both the funding and the commission issues, using omnibus trading and a separate fee structure. ETF providers are keenly focused on tapping into this market, where its lower costs would convey significant long-term return advantages for retirement investors.

Innovative Product Developments

Since its beginnings in 1993, the ETF industry has been a hotbed of innovation. It continues that tradition to this day. Actively managed ETFs, leveraged commodity funds and emerging market bond exposure are just a few of the nonmainstream products coming to market. Funds in development include hedge fund replication ETFs, credit default swap ETFs and emerging market sector funds.

With just 698 ETFs in the U.S. at the end of 2008, compared with over 8,000 mutual funds, according to the Investment Company Institute, the ETF industry appears to have room to grow. There are even more opportunities internationally, where many markets are “greenfield.”
In the U.S. alone, at the end of 2008, more than 500 exchange-traded products were in registration. And yet 2008 was also a year of retrenchment for the industry. Fifty-eight ETFs in the U.S. closed their doors, and over 200 had assets under management of less than $10 million. The lessons learned have been stark—in order to gain critical mass, new products have to make sense, they need to be structured to maximize liquidity and minimize spreads, and they need to be marketed well.

Established Managers

As ETFs become mainstream, more and more asset management firms that had previously focused exclusively on mutual funds have targeted the ETF space. For smaller companies, such as Van Eck Global, the shift to ETFs has been relatively obvious. But for many companies, there is both a business model and a cultural shift required.

In 2009, PIMCO—the world’s leading bond fund manager—is entering the ETF space for the first time. Charles Schwab, long in the position of selling its own index mutual funds alongside competitors, has announced its own plans to launch a broad U.S. equity ETF. Mutual fund manager Dreyfus established a partnership with ETF company WisdomTree in 2008 to manage and distribute international cash and fixed-income products.

Others, from Eaton Vance to the socially responsible mutual fund company Pax World, are eyeing the space as well. In some cases, these moves may simply be to stem the flow of funds leaving for other ETFs. However, the increasing potential for higher-fee, actively managed ETFs (which disclose holdings at least daily), make them an option for viable transition to an ETF- dominated product set, even for traditional mutual fund managers.

As these entrenched asset managers move into the market, ETFs will continue to gain mind share among investors, and fund flows and asset growth should accelerate.