Less expensive, highly liquid, exchange-traded funds (ETFs) have become one of the dominant asset classes for the buy-side, drawing funds away from traditional investment vehicles. With little evidence that the ETF market will cool, active managers are looking to adapt their product and service offerings to meet changing investor appetites.
ETF growth set to continue
Key insights
- The ETF market is expected to see further growth, driving active asset managers to adapt or innovate
- Smart beta products are taking a growing share of the overall ETF market and could become the dominant segment
ETF market capitalization has soared to from USD 500 billion in 2008 to USD 4.4 trillion at the end of 2017 and is on track to reach USD 7.6 trillion by the end of 2020, according to EY.1 The popularity of ETF investing has also driven a huge proliferation in product offerings across virtually every asset class.
The number of ETFs traded globally increased from approximately 4,800 to 5,400 during 2017,2 with growth levels exceeding traditional investment vehicles. In the United States, investors put more than USD 425 billion into domestic ETFs in 2017, almost double the previous record, and more than mutual funds have ever attracted in a 12-month period during their 100-year history.3
Driving down costs
Actively managed funds still account for the majority of funds, but that dominance is steadily declining. In 2016, active funds held 71 percent of the industry's global assets under management, against 17 percent for passive funds and 12 percent for alternative asset funds, according to PwC.4 By 2025, PwC expects passive market share to rise to 25 percent and alternatives to 15 percent, pushing down active management's share to 60 percent.
The shift is being driven by a combination of factors, including the simplicity associated with passive funds, and the low cost as compared to actively managed funds
The shift is being driven by a combination of factors, including the simplicity associated with passive funds, and the low cost as compared to actively managed funds. Prevailing low yields on investment-grade bonds have also driven more investors toward ETFs, along with demographic influences.5 Investors under 40 years of age are almost three times more likely than those in the 40 to 64 age bracket to invest in ETFs, according to British financial research firm Platforum.6
Joining in
The rise of ETFs is compelling active managers to adapt and innovate. Many have responded by cutting fees. In 2017, more than 650 actively managed US equity funds, or about 37 percent of the 1,750 funds tracked in this category, lowered their management fees.7 In 2016, by comparison, 469 funds reduced fees.
Active managers have also sought to tap into the ETF market with proprietary offerings. JPMorgan, Franklin Templeton and Fidelity have boosted their ETF business in recent years. Templeton, for example, recently began trading its first passive ETFs.8
Asset service providers are enhancing resources and capabilities to meet the increase in demand from asset managers that are shifting into ETFs
At the same time, custodians and asset service providers are enhancing resources and capabilities to meet the increase in demand from asset managers that are shifting into ETFs. Canada's Bristol Gate Capital Partners noted that, “Although our firm is 12 years old, we are new to the ETF business, which made it important to work with a trusted partner like RBC who has a strong technology platform as we launch our dividend growth focused active ETFs.” 9
Europe's growing appetite for ETFs
Like their American counterparts, European investors are also attracted to ETFs. In 2017, the European ETF market stood at more than USD 802 billion.10 “We are just starting the journey the US has seen over the last five years or so," said Stephen Cohen, head of BlackRock's iShares ETF business in Europe, the Middle East and Africa.11
Compared to the US, however, the market remains highly fragmented with trades spread across some 25 exchanges and a relatively low proportion of retail investors. Prior to the implementation of the second Market in Financial Instruments Directive in January 2018, a lack of data on pricing and liquidity may have been a deterrent to European Union investors taking up ETFs, although new reporting requirements could spur the market.12
Smart beta ETFs are a rising force
As traditional managed funds contract, actively managed ETFs, including smart beta ETFs, are also growing and could eventually become the dominant segment in the ETF sector. Smart beta ETFs, which take a passive strategy and modify it according to one or more investment factors, surpassed USD 1 trillion at the end of 2017, according to Morningstar.13
BlackRock and Vanguard dominate the smart beta market, with each holding more than USD 100 billion in assets. However, more fund managers are entering the sector, which offers products at a pricing premium above passive ETFs but significantly less than typical managed funds. The flood into the segment is in keeping with the broader shift from active to passive investment, said Marc Knowles, an ETF specialist at KPMG. “They look at that and are compelled to address (it)," Knowles said. “Smart beta is absolutely something (asset managers) are looking at."14