Why are ETFs growing so fast?

The evolution of exchange-traded funds (ETFs) is like watching the emergence of a promising new technology. From humble roots, it has morphed into an indispensable tool, thanks to relentless innovation.

Total ETF assets exceeded USD 10 trillion globally at the end of 2021, up by nearly 30% year-over-year and capping two consecutive years of record growth. In addition, the number of ETFs grew from over 450 in 2005 to a total of nearly 8,600 funds 16 years later.1


ETF

Key to the ongoing popularity of ETFs is investor confidence in the vehicle and the market as a whole, according to Ken Martin, Director of ETF Product Development at RBC Investor & Treasury Services.

1. ETF buoyancy is due to innovation—and successful stress testing

“ETFs aren't some overnight phenomenon,” Martin points out. “They've been around for more than three decades.” However, demand has soared in recent years because of the sector's dynamic rate of innovation. This includes the introduction of active investment funds, the relatively new semi-transparent structures and the rise of thematic funds, which allow investors to buy into sectors or trends.

And over the past two years, ETFs have been stress tested in difficult market conditions, largely due to a world hard-hit by the pandemic and inflation. Stimulus spending has also helped to underpin economies and markets. "Naturally, people rushed to invest on the fear of missing out, and an ETF product was the choice for market access."

2. Mutual fund conversions are spurring ETF growth

Mutual fund managers have begun looking to convert their funds into ETFs to attract additional investors. ETFs are typically a more cost-effective vehicle, while offering diversification that pares risk. Liquidity and simplicity are key calling cards, helping to attract greater investment flows for asset managers. "In the last 12 months, you've started to see asset managers in the US, the world’s largest market, switch their mutual funds into the ETF space," said Martin.

3. Actively managed ETFs are a popular option

ETFs generally began life as a passive product that tracked an underlying index. These products were highly liquid and offered more favourable cost structures than mutual funds. Today, the actively-managed ETF, where a manager or team decides on asset allocations, is thriving, as investors seek index-beating returns. "Investors have become more familiar and more confident with the ETF product, and they're now starting to look for above-index returns," said Martin. "So active is a solution."

4. Expect more ETF creation as managers protect their "secret sauce"

The fully transparent active ETF has a drawback: Managers are required to disclose their portfolio daily, which means that trading strategies are on full view for competitors who might want to mimic their winning strategies.

“There was a reluctance among active managers to enter the ETF space because they didn't want to disclose their secret sauce," said Martin. So, the industry devised semi-transparent structures where they disclose the portfolio less frequently, or via a proxy basket or an intermediary. He expects this new paradigm to draw more managers into the arena because they can protect their proprietary game plans.

5. From ESG to digital, thematic investing is in demand

"A major growth area is thematic ETFs," said Martin, explaining that investors generally prefer to invest in trends, rather than a specific strategy. These themes encompass sectors such as the environment, crypto, technology, artificial intelligence and robotics.

Martin noted that Europe is leading the way in embracing ESG (environmental, social and governance) investing. European investors plowed some 50% of their ETF investments, or USD 66 billion, into ESG vehicles during the first seven months of 2021, according to Trackinsight, an ETF analysis platform.2

The digital space is also growing, especially in Canada where direct ownership of underlying cryptocurrency is allowed, unlike in the US, where only futures-based digital products are permitted. "We see crypto playing an important role in ETF funds moving forward," he said.

Final word

ETFs have become a fundamental tool for the investor and asset manager alike. The vehicle was validated as an investment strategy during a period particularly hard hit by the COVID-19 virus. But new global challenges lie ahead. Macroeconomic factors may spark demand for even more innovative strategies, such as commodity ETFs.

 

 

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