Exchange-traded-fund assets are expected to reach $7.6 trillion by the end of 2020, up from an estimated $4.4 trillion at the end of September, according to a new report by EY, a consultancy firm.
Several factors favor ETFs’ fast global expansion, the report said. These include the shift to passive investing, low yields, regulatory efforts around suitability and value of money, and digital distribution.
Registered investment advisors contributed the largest net flows into ETFs with $132 billion in the year ended Sept. 30.
The EY report was based on interviews conducted between May and September with 70 leading ETF promoters, market makers and service providers across the U.S., Europe and Asia. Respondents collectively manage 85% of global ETF assets.
Two-thirds of respondents said they expected most managers to have an ETF offering in the next five years.
The report said ETF providers could expect to face new challenges as the industry grows in size and influence. “ETFs can no longer just be cheaper or more liquid than actively managed mutual funds,” Lisa Kealy, EY EMEIA Wealth & Asset Management ETF leader, said in a statement.
“The industry will need to innovate around investors, refine investor journeys and reduce investor costs to remain competitive.”
Anticipating Investors’ Needs
Both current and new investors will transform the ETF market, according to the report. Between 15% and 25% of ETF inflows will come from new investors over the next three years, some $250 billion.
Investors, the report noted, typically first use ETFs for exposures they cannot access elsewhere, but then become more comfortable using them as the building blocks of portfolio construction.
Nearly all interviewees said institutional investors would continue to dominate ETF investing through the end of this decade. Wealth managers, private banks and investment funds are promising areas for growth, the report said.
Pension funds will likely use ETFs for liquidity management while wealth managers can be expected to look for core exposure through model portfolios. Some hedge funds will use leveraged and inverse ETFs to execute high-conviction long or short positions.
The research showed that only 2.9% of inflows currently go to funds that manage less than $100 million in assets. Fifty-five percent of respondents said they did not expect the success ratio of new launches to improve in the future.
According to the report, ETF providers will need to anticipate investor needs, incorporate macro trends in regulation and technology, and focus on educating investors. Product development will take many forms, including new thematic ETFs, greater access to debt and investing in alternatives.
ETF offerings will help new entrants defend against declining mutual fund inflows, the report said. For many of them, ETFs will form only a part of their product range and will focus on emerging areas, such as smart beta.
At the end of July, smart beta equity funds and products listed globally reached a new record of $607 billion.
Falling Fees and Regulation
EY said becoming a low-cost provider is a prerequisite to survival. Last year, ETF fees dropped to an average 27 basis points, and 71% of interviewees expected fees to fall further.
Assets in passive funds will exceed assets in active funds globally in 10 years, EY said, and ETFs will benefit disproportionately from this shift because of their low fees and intraday liquidity in volatile markets.
Beyond top-line fees, firms are future-proofing operating models by looking to reduce all costs of ownership. Forty-three percent of respondents said there was not enough competition between index providers, and expected more players to enter the space, including more self-indexing.
Participating in stock lending programs, digital distribution and best execution are other ways to continue to bring down costs for investors.
Sixty-one percent of those interviewed said they expected regulation to change the way ETFs are distributed.
The report said ETFs should, in aggregate, benefit from regulatory changes, such as the Department of Labor Fiduciary Rule and MiFID II, as these changes should lead to greater transparency. But as the regulatory landscape continues to grow, the industry’s systemic risk and taxation are receiving additional scrutiny.
The industry needs to address market and regulatory threats and be willing to respond by developing new products and modifying existing products,” Matt Forstenhausler, EY global and Americas Wealth & Asset Management ETF leader, said in the statement.
“A combination of local understanding and global insights can help investors understand the overall business environment and how this will impact investor journeys.”
EY said that promoters that reshape around investors will find it easier to protect themselves against the increasing strategic pressures providers of all sizes face.