ETF innovation: where next?

In the early 2000s assets under management (AUM) for exchange-traded funds (ETFs) were less than $500bn globally and in Europe they were less than $100bn. The industry was growing rapidly but no one would have estimated that it would have eclipsed the hedge fund industry in a third of the time. Today AUM is a massive $4.8trn.

It's hard to say why the growth is so great but a lot of it can be summed up in one word - innovation. The ETF industry continually reinvents itself and innovation is the primary driver for this.

ETFs burst on to the scene in the 1990s in the US and then experienced rapid adoption in the noughties by investors who saw the wrapper as the preferred method to gain cheap, transparent and robust passive exposure.

ETFs were issued at a rapid rate and initially focused on giving exposure to the main equity market benchmarks globally such as the S&P 500, Eurostoxx 50 and FTSE 100. All of a sudden investors could invest in broad market exposures in one single trade and at a fee less than 0.5%.

The above emergence of benchmark ETFs allowed any investor to be able to construct their own portfolios in a highly cost-efficient manner. This democracy in investing coincided with increased scrutiny on fund managers and financial advisers who had long been earning healthy livings without being accountable for making reasonable returns for a client. For too long advisers were paid by the fund management company to use their product and not seek to use the best and most efficient product available.

As time went on many more ETFs started to emerge across all asset classes. ETFs worked best when they gave all investors access to difficult to invest in asset classes. While taken for granted now, back then they included commodities - both futures backed and physical ETFs such as gold - corporate and government bonds, currencies, emerging and frontier markets and so much more. This revolution started in the early 2000s and was largely complete by the end of the decade.

A clever turn of events

The most recent period of innovation has come from so-called smart beta. This is essentially clever indexing. It's a combination of ways to try and counter the shortcomings of market capitalisation indices - such as overbuying high price stocks and underbuying value stocks. Early entrants looked at dividends or single factor investing like growth and value. Over time ETF payouts have got more adventurous and many include multi-factor payouts.

Smart beta has really shone a light on so-called active managers in the mutual fund world. Many of these funds have underperformed basic market capitalisation indices, while many are also termed benchmark huggers as they correlate strongly to benchmark indices such as MSCI World. The worst sins of such products is the poor performance and very high fees. Many charge in excess of 1.5% compared to ETFs that now come in as cheap as 0.05%. While smart beta is more expensive, it still only comes in around the 0.5% mark.

So where does the next wave of innovation lie? ETFs are not a passive asset class, they are a wrapper with a payout. The wrapper is simply better technology than mutual funds for a variety of reasons. An analogy would be that ETFs are digital technology, whereas mutual funds are stuck in analogue mode. It took a long time to get rid of analogue but eventually it disappeared. It is not inconceivable that in the next 10 years ETFs will offer pay outs in all areas of active management. The only thing you won't see is illiquid exposures that can't be hedged in real time, such as physical property or private equity, but even here, you never know.

A new breed

To allow this to happen many of the traditional fund managers need to enter the market and update their product lines, offering ETFs alongside their mutual funds. Many know this is the reality and are scratching their heads as to how to enter the market in a time and cost-efficient manner. All look at the behemoth iShares and see huge barriers to entry. The conclusion they reach is they want the ETF product but not an ETF business, at least at first.

This is why HANetf has been set up to crash these barriers to entry. HANetf offers a state of the art platform for mutual fund companies to issue ETFs via a platform, while avoiding significant fixed costs and the time it takes to bring solutions to market. What this will lead to is a new breed of ETF provider who will issue a handful of highly specialised ETFs adding to the rich tapestry that already exists.

What does this mean for the broader ETF industry? Given the scale and scope for ETFs it would not be a shock if global AUM exceeds as much as $10tn in the next 10 years, with the number of ETF providers also exploding as this opportunity makes itself obvious.


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