From the September 2012 issue of Investment Advisor • Subscribe!

August 21, 2012

Contemplating Capacity: Where Do We Go From Here?

The next wave of ETP innovation will likely focus on fine tuning exposure within asset classes.

Over the past two decades, the ETF industry has grown to asset levels that few predicted when the first U.S.-listed ETF was launched in 1993. In its early stages, the ETF industry offered only a handful of funds that tracked prominent domestic equity indexes. Today, exchange-traded products (ETPs—including ETFs, ETNs and other exchange-traded structures) offer liquid, low-cost exposure to a wide range of additional asset classes, including international equities, fixed income securities, commodities and currencies, along with a variety of sub-categories within each of these asset classes. This year, we expect the number of ETPs listed in the United States to exceed 1,500, with over $1.2 trillion in assets under management, which raises the question: How much capacity exists for future ETP industry growth?

To answer this question, we can start by looking back at historical growth rates of ETP industry assets under management. Over the past 10 years, ETP assets have grown at an annual rate of about 30%, despite the fact that equities, which represent the largest group of ETP assets, essentially moved sideways during the same time period. During the last five years, this growth rate slowed to about 22%, which is understandable considering the timing of the financial crisis and its effects on equities and other risky assets from late 2008 to early 2009. Over the past three years, asset growth has reaccelerated to an annual rate of about 25%. Whether or not ETP asset growth continues to accelerate at these robust historical rates or begins to level off will largely depend on a few key factors.

Underpinning historical asset growth has been the ability of ETPs to expand into new, untapped asset classes. As domestic equity ETPs lost ground a few years ago, ETPs in other asset classes, such as fixed income, experienced increased demand. Today, only four of the 10 largest ETPs track U.S. stocks. In fact, even as domestic equity ETPs have recovered over the past three years, net inflows for this category have trailed behind both international equity ETPs and fixed income ETPs. Commodity ETPs have also received strong inflows. Without the inclusion of these additional asset classes, the ETP industry would be less than half its current size. While most of the low-hanging fruit has already been gathered, future asset growth will depend partly on how successful ETP sponsors are in introducing additional asset classes into exchange-traded products.

Because there are fewer unexplored asset classes remaining, the next wave of ETP innovation will likely focus on fine tuning exposure within asset classes. One case in point over the last few years has been the surge in issuance of new equity income ETPs. These funds, which diverge from traditional market-cap weighted indexes in order to provide conservative, dividend-focused strategies, have been successful in gathering new assets even as broad domestic equity index ETPs faced net outflows. Another example of product innovation within an existing ETP asset class is the introduction of various strategies by which commodity futures ETPs seek to minimize the potentially negative impact of rolling from one month’s futures contract to another. In order to maintain asset growth trends during the next decade, ETP sponsors must continue to seek new and better ways to provide exposure to a variety of asset classes.

In addition to product innovation, there are a number of external factors that will impact ETP industry growth. For example, a continuation of the shift among financial advisors from commission-based compensation to fee-based advisory compensation tends to favor ETPs over mutual funds. Comparatively, ETPs are not only generally cheaper and more transparent than most traditional mutual funds, they also offer superior tradability, providing investment advisors greater flexibility to make portfolio changes.

Another important factor to consider when assessing future growth potential of the ETP industry is how changing regulations might impact asset flows. While it’s difficult to predict the shape that future regulations might take, it seems likely that prospective guidelines would generally favor greater transparency and lower fees—both areas in which ETPs already provide a significant advantage over traditional mutual funds.

Also, as discussed in July’s ETF Advisor column, 401(k) plans offer another potential source of ETP industry growth (see “Square Peg in a Round Hole?” Investment Advisor, July 2012). Thus far, these plans remain largely untapped, with ETPs representing less than 1% of total 401(k) assets. In my opinion, the fine-tuned exposure offered by certain ETPs will eventually lead to more widespread adoption by 401(k) plans. For ETP sponsors, the $4.9 trillion in plan assets provides a powerful incentive to find ways to make this happen.

For the ETP industry, there remains an abundance of opportunity for future growth. Just as the last decade broadened out the ETP industry via the introduction of new asset classes, the next decade will likely deepen the industry as new types of ETPs are introduced within those asset classes. New and innovative approaches among ETPs, including active management, will compete more directly with traditional mutual funds. As investment advisors continue to gain familiarity and comfort with the ETP structure, its advantages in terms of transparency, cost, and tradability will likely persist in drawing assets away from other packaged investment vehicles.

Page 1 of 2
Single page view Reprints Discuss this story
This is where the comments go.