In two weeks, the curtain will close on 2009, bringing to an end a banner year for the ETF industry that saw hundreds of fund launches and tens of billions of dollars in cash inflows. Ongoing product development and innovation continues to expand investor options, bringing almost every corner of the investable asset universe within reach to millions of investors.
As we look ahead to 2010, one thing is crystal clear: ETFs are the future. And the future is bright.
What is less clear is any of the particulars of this bright future. The last five years have seen countless innovations and unexpected developments that transformed ETFs from a closet industry to a mainstream investment option. The next ten years will certainly bring some interesting developments as well.
December always brings countless predictions for what the year ahead will bring. We’ve decided to look beyond the coming year, focusing instead on ten trends that will make news in the ETF industry over the next decade:
10. Great Bond Boom Of 2010 (And Beyond)
According to our ETF Screener, there are almost 650 equity ETFs listed in the U.S. and only about 90 bond funds. We understand that fixed income investing isn’t nearly as sexy as stock picking, but the paucity of bond ETFs is alarming. As many investors have learned over the last few years, an allocation to fixed income is vital, as it can help to smooth portfolio volatility during rocky times for equity markets.
There are some good reasons behind the lack of development in the bond ETF space, including inherent flaws in some bond indexes and issues with the manner in which bond ETFs operate (the guys at Index Universe did a great job discussing these here and here). But bonds are simply too important of an asset class to remain on the periphery for much longer, and there is clearly demand for bond exposure through the ETF structure (TIP, LQD, and AGG have more than $40 billion in aggregate assets).
The number of bond ETFs available to U.S. investors will increase significantly in the coming decade, and most of these fixed income funds should attract significant assets. The boom has already begun, with bond giant PIMCO making a successful entry into the ETF space and several issuers, including Vanguard, State Street, PowerShares, and iShares, expanding their fixed income offerings in recent months. Other filings, such as Claymore’s plan for a line of corporate bond ETFs, show the potential for new product innovation in this space.
9. Price Wars
The rise of the ETF industry is often attributed to the reduced cost structure relative to mutual funds, an obvious draw for investors frustrated with the “inconsistent alpha” of pricey active management. But this draw to cost-efficient investment vehicles makes it difficult to understand why so many ETF investors are, simply put, getting ripped off. Many of the the most popular ETFs are actually quite expensive, and in several instances there are much cheaper alternatives offering nearly identical exposure (see Five Ways To Slash Your ETF Expenses for a look at several cost-cutting opportunities).
It has become incredibly difficult to justify owning EEM over VWO or DJP over DJCI or AGG over BND. Despite uncompetitive pricing, many of these ETFs have thrived, boosted perhaps by name awareness and the benefit of being first-to-market. But now this trend is beginning to reverse. VWO has been gaining on EEM, and DJCI has seen strong cash inflows since inception. The entrance of Charles Schwab and introduction of 8-basis point ETFs adds further weight upon swollen expense ratios, and sets the stage for a series of price wars in the years ahead.
As investors continue to gravitate towards the most cost-efficient of exchange-traded products, pressure will begin to mount on issuers to offer competitive pricing or risk losing share to low-cost competitors. Expect the 2010s to bring lower expense ratios to dozens of ETFs, a development most investors will cheer and mutual funds will lament.
8. Whole Lotta M&A
It seems hard to imagine seeing an uptick in acquisition activity from 2009, a year that saw a blockbuster deal for market leader iShares and a smaller (but still rather large) acquisition of Claymore by Guggenheim Partners. But don’t be surprised if a wave of M&A activity sweeps across the ETF industry in the next decade, altering the competitive landscape and leaving few of the current names the same.
There are a few factors that indicate a wave of M&A activity is inevitable. First, as cost competition among ETFs drives down expense ratios (see #2), the breakeven point for ETF issuers will be driven up. An ETF charging an expense ratio of 0.50% needs $200 million in assets just to generate $1 million in annual revenues. In order to survive, some issuers will need to band together.
The second reason is that there are simply too many big players in the mutual fund space (and financial industry in general) who have watched the ETF boom from the sidelines. Schwab’s entry into the ETF industry has been incredibly successful by most accounts, but the relative assets accumulated remain quite small (only 0.04% of iShares assets through November), and the business likely faces years of losses before reaching a breakeven point (especially considering the rock bottom expenses). For companies looking to make a splash in the ETF space, the preferred route may be to acquire an existing issuer with a large asset base. Currently, there are more than a dozen ETF issuers with at least $1.5 billion in assets, meaning that those on the outside looking in (such as Fidelity, American Funds, Oppenheimer) have a lot of options.
7. MacroShares Rules The World (Sort Of…)
The exchange-traded products by MacroShares have been slow to catch on with investors and often criticized for some of their shortcomings (if you’re not familiar with how the MacroShares products work, see this overview). The first Oil Up and Oil Down funds closed when crude prices skyrocketed, essentially bankrupting the down fund. The second was slow to accumulate assets, and was shuttered long before its maturity. So to say these funds have had some issues is a bit of an understatement.
But the basic concept behind the MacroShares products (two opposite funds pledging assets to each other based on the level of a reference index) is sound, and has tremendous potential in a variety of applications. For investors looking to hedge against (or speculate on) economic indicators, commodity prices, or other metrics, the most efficient way to do so may be through a position opposite another investor with a differing view (the massive size of the futures market is certainly a good indication of this).
The coming years will bring continued innovation to the “paired ETF” concept, and hopefully a complete line of exchange-traded pairs that allow investors to bet on a number of events, ranging from oil and natural gas prices to inflation to unemployment and interest rates. Given the popularity of UNG and the rapt attention given to Fed meetings and employment reports, such products, if done correctly, could become tremendously popular with investors. The potential here is huge, and is only amplified by expanding or contracting the time horizons over which the products would pledge assets to each other.
6. Lots of Fund Launches, Lots of Fund Closures
Many analysts believe the ETF industry is quickly approaching its saturation point. Others think that it already has, anticipating a wave of fund closures in coming years that will greatly reduce the number of available ETFs. There will undoubtedly be some ETFs that close their doors in the years to come. In years past, issuers have rushed many ill-conceived funds to market, hoping that the advantage of being first to market in a narrow product space would be enough to ensure success. Now many of these ETFs are reaching three and five year milestones with less than $10 million in assets. The termination of some of these ETFs is inevitable.
But new fund launches will continue, and may even accelerate. There are a number of good ideas that are yet to be introduced or have only begun to draw investor attention. Sector-specific international ETFs have already begun to pop up, with Emerging Global Advisors and Global X (and Claymore to a lesser extent) pioneering this space in emerging markets and China, respectively. Hedge fund ETFs, another area with significant potential, have experienced “proof of concept.” The bond ETF space remains severely underdeveloped (see#1), as do several other areas. Potential for continued innovation in the leveraged ETF space exists as well.
The ETF industry is far from its saturation point, and will continue to expand rapidly in the coming decade, both in terms of assets and number of funds.
5. Vanguard Reigns Supreme
iShares has established itself as the most dominant player in the ETF industry, grabbing nearly 50% of the market share and boasting dozens of the most popular ETFs. So it’s hard to imagine the issuer being toppled from its perch anytime soon. But Vanguard has begun to close the gap, taking in $5.4 billion in cash inflows in November. This pull bested all other issuers, including iShares (which took in $4.2 billion). These monthly results are even more impressive considering that Vanguard maintains about 45 ETFs while iShares offers almost 190.
According to the latest numbers, Vanguard is the third largest ETF issuer, well behind both iShares and State Street. But momentum is clearly beginning to build, and it wouldn’t be surprising if the firm founded by Jack Bogle stands as the largest ETF issuer by the time the next decade draws to a close.
4. Advisors Embrace ETFs
It is perhaps a bit frightening to realize that there is a significant portion of the financial advisor community that not only isn’t using ETFs, but isn’t even fully aware of what these products are and how they work. But that’s going to change, and change very quickly. As clients learn the benefits of ETFs relative to mutual funds, they are pushing advisors to use ETFs in their portfolio. Moreover, many ETF issuers have conducted aggressive campaigns to educate advisors around the country on the benefits of ETFs.
Use of ETFs among financial advisors has surged in recent years, but there is still plenty of room for growth. I should point out that there are a number of “ETF-friendly” advisors that are already using these funds in most of their client portfolio.
3. Leveraged ETFs Boom
Many in the ETF industry were predicting the downfall of leveraged ETFs in 2009, pointing to public outrage over the performance of these funds in volatile markets (much of which was unfounded), increasingly strict regulatory requirements, and the likelihood of huge capital gains distributions. But instead leveraged ETFs have boomed this year, as investors came to realize that leveraged ETFs actually do an excellent job of accomplishing their stated objective and most funds declared zero (or minimal) capital gains distributions. ProShares and Direxion saw cash inflows of $8.5 billion and $5.4 billion, respectively, through the first 11 months of 2009, a clear indication that demand for these products remains.
Having come through a gauntlet of challenges unscathed, the leveraged ETF industry is poised for major expansion. There are a number of asset classes and sub-classes that are still not covered by leveraged ETFs, indicating huge potential for new fund launches and asset accumulation.
2. Active ETFs Stay On The Periphery
There’s been a lot of hype surrounding actively-managed ETFs, with many industry insiders predicting these line-blurring products will drive the next wave of growth in the ETF industry. But all evidence to date is to the contrary. Some of the first active products launched by PowerShares have delivered impressive results (PSR, for example, has crushed its benchmark), but have been slow to gain traction with investors.
Likewise, Grail’s actively-managed ETF, which launched with huge fanfare in May of this year, has only about $3 million in assets. Several ETF issuers have filed for SEC approval on actively-managed ETFs, no doubt watching the investor reaction to Grail’s ETFs very closely. But as these funds have struggled, the floodgates have remained closed, with only a handful of new active ETFs hitting the market.
For those expecting the active ETF boom, don’t hold your breath. The ETF industry will continue to be dominated by traditional passively-indexed funds for the foreseeable future.
1. 401(k) Push Continues…Slowly
The rise of the ETF industry — according to NSX data, assets totaled more than $750 billion at the end of November — is made even more impressive by the fact that these funds are unavailable in most 401(k) plans, shut out by logistical incompatibility. The arguments against inclusion of ETFs in 401(k) plans — that they would make the plans more expensive to operate and that the demand for them hasn’t yet materialized — seem ridiculous, but breaking through the retirement account wall has proved to be a formidable challenge.
There are reasons to be optimistic about increased availability of ETFs within 401(k)s. BlackRock stressed this expansion opportunity when making its bid for iShares earlier this year. And there are an increasing number of plan sponsors that make ETFs widely available.
But the challenges ahead are significant. Roughly 90% of the $1.5 trillion in 401(k) plans are in actively-managed products. This represents a major source of income to mutual fund companies, who are eager to hold on to this lucrative asset base. Mutual fund companies are more likely to participate in “revenue sharing” agreements — making payments to plan administrators. That’s something that many low-cost ETFs may have problems doing.
ETFs will make their way into 401(k) plans eventually. But anyone who believes that their inclusion is imminent hasn’t waded through enough red tape in their life. Don’t be surprised if the same trend tops the list of upcoming developments a decade from now.
Author's Disclosure: Long LQD.