Increasing competition and pressure on fees are among the growing challenges facing ETF issuers over the next five years, according to a report by EY, as the industry looks to adapt to the “new normal” in a post-COVID-19 environment.
The report, entitled Can ETFs scale new heights in an unfamiliar environment?, warned that despite passing the coronavirus test with “flying colours”, ETF issuers were now faced with the challenge of moving to an increasingly digitalised world.
In particular, EY highlighted the increasing rivalry between ETF issuers, slim margins and new entrants into the market as three reasons to suggest competition in the space is only set to intensify.
Over the next three to five years, one of the key challenges for ETF issuers is how they will cope within this environment of falling fees and margins.
“Competition has always been strong in the ETF industry, and recent years have seen growing pressure on margins and profitability,” the report continued. “COVID-19 has only strengthened these dynamics, making further downward pressure on fees and profitability seem inevitable.
“Profitability pressures also increase the risk that short-term cost cutting in areas, such as investor education, could harm the industry’s long-term growth prospects.”
Furthermore, EY said fee pressure has led to an increasing importance of capturing big assets in order to maintain ETF profitability.
However, an EY survey found the competitive landscape in Europe has led to a more cautious approach to launching strategies with the number of ETF issuers confident in the success of ETF launches falling from 57% in 2018 to 46% in 2020.
“The contradiction between the desire to launch new funds and the need for economies of scale will only become more acute as fees decline further.”
In response, EY highlighted a number of areas where ETF issuers can expect drivers of asset growth such as launching new strategies, reaching new investors and improving distribution.
Of the new launches, ESG and fixed income ETFs were highlighted as two key areas of growth while active and thematic were also pointed to.
Meanwhile, in order to improve distribution, EY said many ETF issuers were looking to take advantage of the shift toward remote advice and online sales to scale up their digital capabilities.
“But it remains to be seen whether issuers can provide sufficient transparency, disclosure and convenience to encourage greater take-up via channels such as robo-advisers and online fund platforms,” the report added.
“ETF providers that can develop and deliver an effective strategy for growth in the post-COVID world will be better placed than ever to create sustainable value for investors and society at large and, in the process, for themselves.”
The ‘new normal’
According to the report, ETF issuers must adapt their plans to the post-pandemic environment if they want to achieve sustainable growth.
This, EY argued, will be achieved through four areas over the next five years; navigating regulation, getting ESG investing right, rethinking investor experiences and transforming business models with technology and data.
Regulation remains a key risk for ETF issuers especially following the UK’s exit from the European Union.
While the UK’s Temporary Permissions Regime (TPR) enables efficient trading over the next two to three years, EY said there are questions about the long-term impact of the end of “passporting”.
“This is not unique to ETFs, but any need to duplicate funds would pose a particular threat to the efficiency of the ETF model,” the report stressed.
“Issuers must ensure that regulatory awareness, compliance and flexibility are built into their culture, particularly around product development, and that ETFs continue to provide high standards of transparency over product holdings, structure and operations.”
The rise of ESG investing is also a major growth area for ETF issuers and is crucial to their long-term performance, EY argued.
However, rising regulatory demands and increasing investor expectations of long-term stewardship, means the sustainable investing landscape is not a straightforward one.
In order to have success in the ESG ETF space, EY recommended issuers develop a distinctive approach to engagement, offer ESG education and embed sustainability across the whole ETF range.
“The compelling opportunities for ESG-themed ETFs need to be balanced against fast-growing expectations from regulators, investors and the public, the report continued. “It is vital for promoters to set out a coherent vision of sustainable investing and to clearly differentiate themselves.”