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The aggressive rise of passive investing
The aggressive rise of passive investing
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The aggressive rise of passive investing

08/06/2017

In less than three decades, exchange traded funds (ETFs) have grown to become one of the most important items in the investment toolkit, providing versatile and low cost exposures to investors around the world

This spring BNP Paribas hosted a hackathon which brought together clients and staff for two days of innovative workshops and brainstorming to discover the full potential of ETFs in Europe. The event focused on two areas of improvement: ETF trading and education. ETFGI's Managing Partner, Deborah Fuhr, one of the featured speakers at the event, examines the reasons for the inexorable rise of ETFs and looks at the challenges that the industry faces.

Record breaking inflows

ETFs are one of the big success stories in finance today. March 2017 represented the 38th consecutive month of positive net new asset flows into ETFs, a record that few other products can match. With USD 197 billion in net new money invested in ETFs in the first quarter of 2017, compared to USD 390 billion for the entire year of 2016, it was also a record-breaking quarter for inflows.

The US leads in the ETF industry with 71% of assets under management (AUM) globally or USD 2.8 trillion followed by Europe with 16% or USD 640 billion and Japan with 5% or USD 207 billion. With a relatively modest USD 136 billion invested in the rest of Asia Pacific, this region is set to see considerable growth in coming years.

Broad investor appeal

A number of macroeconomic trends make ETFs attractive to investors of various types. The low yield environment has helped ETFs gain the most traction in recent years. With returns being squeezed, investors are increasingly searching for lower cost alternatives like ETFs, which many believe can deliver better real returns.

ETFs provide a simplicity and transparency for investors allowing them to buy or sell on secondary markets throughout the day and the ability to hold on margin, short, and option. A unique feature of ETFs is that they offer the same broad suite of products for all investors, regardless of whether they are institutional or retail. Investors have access to all areas of the capital markets – particularly, asset classes which previously were too costly and difficult for small institutional and retail investors to own.

There is no other product with such broad investor appeal. ETFs attract short term investors because they are often cheaper than futures; they help tactical investors that wish to adjust their allocations without changing their underlying mandates; and they serve long term investors, with 47% of ETFs being held for more than two years.

A growing opportunity

The increasing popularity of socially responsible investments (SRI) has created an opportunity for ETFs. They have grown to provide exposure to new indexes based on SRI, renewable energy and other niche sectors investors may want to invest in. ETFs can also provide a more convenient exposure to countries – particularly in emerging markets – where investors have struggled to find suitable investments. If a mainstream China index is created, a surge of allocations to ETFs based on it will surely follow - especially given how difficult it has been for foreign investors to access the world's second largest economy.

Increasing allocations to passive investment vehicles are also consistent with the growing interest in robo advisors. Robo advisors are gaining popularity, with brokers like Vanguard and Charles Schwab offering them to investors. ETFs are well suited for robo advisors due to their low cost, simplicity, and exposure to many asset classes.

Challenges in the industry

Challenges still remain, the biggest of which is education. Despite the growth of the industry, ETFs remain poorly understood by many potential investors. Meanwhile, somewhat ironically for a product that has succeeded in part because of its transparency, it can be difficult to get accurate data about ETFs. Due to the fact that ETF money goes to brokers rather than asset managers, the numbers that have been sold can be opaque.

The ETF industry also needs to improve its distribution model – especially in Europe, where there are still greater incentives for financial advisors to steer investors towards other products that pay commission. This has led to Europe lagging behind the US in the use of ETFs by retail investors. However, European regulations such as the Markets in Financial Instruments Directive II (MiFID) and the Retail Distribution Review (RDR), which ban commission by independent financial advisors, are expected to encourage the use of ETFs.

Another improvement for the industry would be the ability to sell ETFs in fractions, as is possible with listed mutual funds. This would make it possible for US 401K plans to allocate to them. All of these challenges are the result of the market's relative youth, and will be resolved in due course.

Meanwhile, ETF structures are likely to evolve with a new breed of active ETFs being developed. These ETFs will report their positions quarterly, rather than daily. Some asset management companies believe this will give those ETFs an advantage by not having to disclose all their investments, which makes it easier for others to trade against them.

What’s next for ETFs?

As the industry matures, ETFs with new asset classes are being developed. In the US, the Securities and Exchange Commission (SEC) is reviewing their earlier decision of rejecting a filing for a bitcoin ETF. Obtaining approval for the bitcoin ETF - called the Winklevoss Bitcoin Trust ETF - has been a three year effect. While the decision from the SEC is still pending, the bitcoin ETF filing shows how these products can evolve to meet the changing preferences of today’s investors.

Asset flows are predicted to continue from developed markets such as the US and Europe. However, the fastest growth will come from less mature ETF markets such as Asia and Latin America. ETFs also are expected to attract new types of investors such as insurers, pension funds, and hedge funds.

The fast rise and growth of ETFs is impressive. Their broad investor appeal, simplicity, and low costs have helped make ETFs – once considered only a niche product- into a global phenomenon.

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