Going Beyond Passive

Murray Bender: RBC Investor & Treasury Services is pleased to present insights on the future of asset and payment services across the globe. Today’s podcast features Ken Martin, Director of ETF Product Development at RBC Investor & Treasury Services, discussing how exchange-traded funds, or ETFs, are evolving to meet the needs of investors. Thanks for joining us, Ken.

Ken Martin: Pleased to be here today, Murray.

Murray Bender: So, Ken, ETFs have been experiencing some fairly significant growth recently. In your view, what are the key drivers behind this growth?

Ken Martin: It’s an interesting question, Murray, and the first point to know, it’s not happened overnight. ETFs have been around for about 30 years. Popularity really took off after the global financial crisis, when investors started to switch from active management, the higher fees, and, at the time, the poor returns associated with them, to passive index ETFs. Being ETFs, they offer lower fees, particularly in the passive space, that provide the investor with liquidity. What do I mean by liquidity? With a mutual fund, when you redeem, you’ll get the NAV calculated at the end of the day. With an ETF, because it’s exchange traded, you can come out or enter throughout the day, so you determine the price which you buy or sell at.

They’re also more tax efficient because, unlike the mutual fund, you decide when you pay tax (i.e., when you sell your ETF shares). This is due to intermediaries in the basket mechanism process, whereas with a mutual fund, the underlying portfolio would be sold to realize the money to redeem your shares and would trigger a capital-gain event.

They’re also very easy to use and easy to understand, and, as I alluded to earlier, trade like a stock. They also offer diversification. What do I mean by diversification? It reduces the risk of the investment. Normally when you’re investing something—investing something, you’ll usually pick a single stock. With an ETF, you’re gaining exposure to a market segment. So let’s, for example, say you want to buy into the S&P 500. Rather than buy one S&P 500 stock, you’d buy exposure to the whole index. So, effectively, you’re investment varies with the return of the index, as opposed to an underlying component in the index, which might not necessarily give you a gain versus the index.

They’re also transparent. You’re able to see what your fund holds on a daily basis, unlike mutual funds, which only publish quarterly in arrears. There’s also no minimums in terms of what you can buy from a monetary value and shares. As a result, this sort of assets doubled to a trillion by 2010, 4 trillion (USD) at the outset of the pandemic, 8 trillion by the end of 2020, and by July of this year, in excess of 9 trillion.

It’s important to note that whilst the last year, which was very stressful to the market, it validated ETFs both as a product and its associated ecosystem, as they would test the limits and, as a result, enhance investors’ confidence in ETF products. Coupled with this, fiscal and monetary policies followed by governments globally to limit the impacts of the pandemic helped propel the market to new highs. Naturally, people rushed to invest on the fear of missing out, and an ETF product was the choice for market access.

Murray Bender: Ken, can you tell us a bit about how ETFs have actually been evolving in recent years?

Ken Martin: I can, Murray. ETFs are constantly evolving and innovating. Key areas of note in the last few years is—the big one has been active ETFs, which is interesting cause they’ve come full circle. The reason they’ve come full circle is because, obviously, passive index investing is not going to give you above-index returns. So, obviously, as investors have become more familiar, more confident with ETF product, they’re now starting to look for above-index returns. So active is the solution.

Unfortunately with ETFs, with the requirement to disclose your portfolio daily, there was a reluctance amongst asset managers to enter this space because they didn’t want to disclose their secret sauce (i.e., what is the technique that is giving the above-index return). So, the industry came up with a solution and it’s called semi-transparent structures, which enables them to disclose the portfolio in some formal format, either via an intermediary or via proxy basket, to overcome that problem, which has helped existing managers with good ETF mutual funds to enter this space.

Thematic, also, is growing exponentially. Usually thematic is associated with tech, such as internet, AI, robotics, but it also involves EV, health care, environmental, social, and digital. And Cathie Wood at ARK is an example of an active asset manager who has put this together with thematics to deliver very successful ETFs during 2020.

Other areas of growth are ETF securities lending. It’s still relatively in its infancy. It offers those investment managers 1 or 2 bps additional return, which will make all the difference in the passive space. Other areas where we’re starting to see growth is in the ESG and in the digital space. In the ESG space in 2020, approximately 90 billion of assets came in; that’s versus 29 billion the year before, and Europe is leading the charge in that area. And, obviously, the digital space, we see all the fun and games going on in the moment in the U.S. where future-based funds are approved but direct access is not, whereas in Canada, which is one of the leading markets of ETF innovation, direct access to underlying digital currency is permitted.

Murray Bender: So you’ve talked about the growth and the evolution of ETFs. What are some of the challenges faced by asset managers when it comes to exchange-traded funds?

Ken Martin: If you look at it, probably the most interesting thing is, obviously, a lot of money is flowing into ETFs. And when asset managers access the ETF market, the key in the first instance is the right entry point for them. As I alluded to earlier, even an existing manager with highly successful active mutual-fund strategies, there is, obviously—there will be a demand for those products in the ETF space, and the transition is relatively straightforward when we come to detail on that.

For new entrants it’s: What am I bringing to the market that differentiates me from the herd? So, for example, using S&P 500, bringing another S&P 500 product to the market is not going to bring you assets because there’s a multitude of products doing that. So you have to do your research. So, as asset managers, particularly new entrants, you need to have access to data to see what is out there, and the opportunities and the toolsets to enable you to do that. Those can either be provided by your TPA (third-party administrator) or your TPA in partnership with other people. Likewise, data concerning inflows, it’s good to know that, once you set your ETF, where the flow’s coming, who are the APs (authorized participants) delivering for me, etc. And, most importantly, when you move from a mutual fund to an ETF, what are the changes that it brings to the ops model for an investment manager (i.e., the requirement to produce the basket, how to ingest the AP trades, and how to deal with the trade burst).

Additionally to that, probably the biggest change from a traditional asset manager is when you move into the ETF space, you’re moving into the brokerage space. And that will impact if you look to convert your mutual fund to an ETF, because a lot of flows into—a lot of the potential capture for ETFs going forward is from converting mutual funds; however, that is very easy when you have specific types of investors. When you have pension funds like 401(k)s investing in mutual funds, you can’t convert them to an ETF cause one of the things with pension funds is they buy fractional shares. Today, ETFs do not offer fractional shares, so that would be an impediment to a wholesale change from a mutual fund to an ETF; however, at the retail level, if you invest via robo investors, they can handle that at the individual level for retail investor.

Murray Bender: So finally, Ken, looking to the future. Where do you see ETFs headed going forward?

Ken Martin: As I alluded to earlier, I think one of the big areas for growth is mutual-fund conversions. In the last 12 months, you’ve started to see that in the U.S., the largest market, you’ve seen certain asset managers, including Dimensional, start to switch their mutual funds into the ETF space. And I am sure there is more to come in that regard. Likewise, we touched on ESG earlier. ESG is growing, but an impediment to ESG reaching its full potential is standardization of the rules around ESG, etc., which is not there today. And also attracting a performance track record. Because, obviously, when you invest, one of the things you’ll look at is track-record performance of the fund. And, likewise, with digital. Digital infancy, as I alluded to earlier, there’s no one solution fits all. Canada has a very innovative ETF market so you can invest directly today into the underlying coin. In the U.S. today, the SEC restricts it via future-based [fund]. I’m sure we’ll see future development ideas in that space.

Additionally, end investor, client experience, user interfaces, an area where asset managers will need to up their game. As I said, you’ve got generational shifts going on and most people will be doing their investing, trading, via iPhone apps or etc., versus going into a bank and sitting down with a broker or investment manager in the bank to make investment decisions. I support that asset managers shift their model to that paradigm going forward.

Murray Bender: Very interesting. Thanks for your time today, Ken. We really appreciate it.

Ken Martin: Thank you, Murray. It was a pleasure to speak.

Murray Bender: Today’s podcast has been brought to you by RBC Investor & Treasury Services, and we hope you found it useful. For additional insights on the future of asset and payment services, including our previous podcasts, visit rbcits.com/insights. I’m Murray Bender. Thanks for listening.

This content is provided for general information and does not constitute financial, tax, legal, or accounting advice, and should not be relied upon in that regard. Neither RBC Investor & Treasury Services nor its affiliates accepts any liability from loss or damage arising from use of the information in this podcast.