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Important Trends Impacting the ETF Industry

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Important Trends Impacting the ETF Industry

INTELLECTUAL CURIOSITY is one of our core values at FlexShares. As such, we pay close attention to important trends impacting the ETF industry and the advisers we serve. Our value proposition is anchored by our collaborative engagement with market participants, intermediaries and investment advisors that serve individual and institutional clients. This active engagement yields rich dialogue and constant opportunities to learn and grow. The combination of active engagement with stakeholders and the deep expertise offered by our investment professionals provides me with a rich viewpoint of the ETF marketplace. To this end, I offer the following perspectives on trends impacting the ETF marketplace. I hope that these unique insights will both peak your own intellectual curiosity and encourage your ongoing engagement with FlexShares as we seek to best serve you.

INDUSTRY OVERVIEW

Exchange-Traded Funds (ETFs) continue to be among the fastest growing product categories in the U.S. asset management industry with, a 10-year CAGR of 17.2%. In 2015, growth in the U.S. market increased +6.7% from the prior year to $2.1 trillion in assets as of 12/31/2015. U.S. listed ETFs attracted $235 billion in inflows in 2015, just shy of the $242 billion in flows from the prior year. The total assets at year-end (YE) represented a record total for the industry while flows logged their second best year ever. 2015 flows were driven primarily by international equity (+$103 billion), which more than doubled its inflows from 2014, thanks in part, to strong demand for currency hedged products. Taxable bonds finished with the second most inflows (+$56 billion), followed by U.S. equity (+$49 billion). It is important to note that the flows to international equities predominantly favored developed economies. Investors in U.S. equites continued to favor the ETF vehicle structure as U.S. equity mutual funds experienced outflows of (-$107) billion. ETFs also continue to take market share in the taxable bond category attracting (+$56 billion) in flows compared to (-$30) billion in outflows for taxable bond mutual funds.

In 2015, there were 277 new U.S. ETF listings but 99 fund closures bringing the YE fund total to 1,840. There was less concentration of fund flows among the top 3 providers as they accounted for $156 billion or 66% of fund flows. This compares to 80% during the prior year. Achieving $100 million in AUM within two years of listing is an accepted measure of initial success attributed to new product listings. 

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A decade ago, nine out of ten ETF listings achieved this milestone versus about one in ten today. During the past two years, 464 new ETFs were listed with 62 (13%) of these funds exceeding the $100 million AUM milestone. This ratio decreased from 2014, when 23% of funds launched within the trailing two years exceeded the $100 million milestone.

Competition continues to intensify as new competitors enter the market. We assert that the keys to success in our industry are evolving due to changing investor attitudes and competitive dynamics. The number of U.S. sponsors has increased from 8 at the end of 2005 to 91 at the end of 2015. A net increase of 27 sponsors occurred in 2015, the most ever in a single year.

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PRODUCT INNOVATION

The first stage of ETF product innovation focused almost exclusively on broad-based equity benchmark indexes. Institutions were primary users of ETFs with an emphasis on tactical applications such as hedging and transition management. This stage, which covered about a decade, gave birth to some of the largest ETFs today. The second stage of innovation witnessed an expansion into a variety of asset classes including fixed income, commodities and real estate. Driven by investor demand for global portfolio exposure, ETFs democratized access to these asset classes. The second stage of innovation was fueled by rising awareness among retail investors and financial advisors.

The current third leg of innovation is categorized by investor demand for distinctive investment strategies with particular interest in alternatively weighted index schemes. A variety of nomenclature is associated with these strategies including fundamentally weighted, factor weighted and the popular “smart beta”. While the lexicon may vary, the trend of growing investor demand for non-traditional index strategies is firmly established. More strategic use of ETFs by institutions such as public funds, foundations, endowments and asset managers combined with broader acceptance by financial advisors is driving flows to ETFs broadly and flows to alternative index strategies specifically. While the term “smart beta” is increasingly being used by investors, morningstar identifies 515 funds with their “strategic beta”. With assets of $455 billion and inflows of $66 billion in 2015, this sub-segment achieved a superior organic growth rate compared to the overall market (12% versus 7%). FlexShares is an emerging leader in this segment with our distinctive approach, which we refer to as “Flexible Indexing”.

At the close of 2015 there were 140 U.S. listed active ETFs with $22.7 billion of assets. While the number of new funds grew during the past year, active ETFs still account for just over 1 percent of U.S. ETF assets. Utilization has been muted since the introduction of the first active ETF in 2008.

The arrival of another competing vehicle structure in the form of exchange traded managed funds (ETMFs) gained regulatory approval in November 2014. This new exchange traded vehicle touts several benefits of ETFs with some notable differences. A unique feature of the new ETMF structure is that there is no daily disclosure requirement similar to that of ETFs. This non-transparent feature is more aptly targeted toward actively managed strategies. The ETMF will employ what is known as NAVbased trading so it will differ from ETFs as it will not have constant price discovery throughout the day, although the funds will be traded on exchanges. Though initially slated to launch in 2015, the first ETMF was recently listed on NASDAQ on February 25, 2016.

Broad acceptance of actively-managed ETFs as well as new vehicles like the ETMF structure will require time and patience. In addition to notable regulatory hurdles for non-transparent active ETFs, broad user acceptance will also require investor education and infrastructure investment by market participants. Nonetheless, the incremental developments on the active front increase the prospects more established active fund managers will enter the ETF space through strategic alliances, acquisitions or de novo builds. As the regulatory picture for active ETFs becomes clearer, I expect actively managed ETFs to spur a fourth leg of innovation.

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Our product strategy at FlexShares remains focused on non-traditional index strategies. The FlexShares’ philosophy centers on the investor. While that seems very basic, it is uncommon. Investors possess real goals. One individual investor may seek to fund a college education for their child through capital appreciation while another needs to manage inflation risk while providing income for retirement years. We start with investors’ goals because that’s what matters but have to ask fundamentally different questions to identify the appropriate solution. We then construct strategies that best meet that objective, which we rigorously vet using empirical research and analysis.

DISTRIBUTION

There are three trends of particular interest as it pertains to ETF distribution. The first trend is the rising cost of distribution; marketing and distribution are critical success factors in the ETF industry. Intermediaries are aggressively seeking to monetize their client relationships through explicit distribution fees or more subtle marketing agreements. The result is higher distribution costs through traditional intermediary channels. This has also spurred strategic partnerships and is enabling existing asset management providers to join the fast growing ETF segment while leveraging and/or combining distribution capabilities.

The second trend relates to the strategic use of ETFs by institutions. The most recent Greenwich Institutional ETF User Survey (Q1 2016) suggests that 68 percent of institutional ETF assets are characterized as strategic in nature. Moreover, institutional users are identifying new applications for ETFs in their portfolios with a growing majority using them as a primary vehicle for implementation of long-term strategies. This has become increasingly important in asset classes such as fixed income where liquidity constraints resulting from regulatory and market structure changes have made it more difficult to manage diversified fixed income portfolios through traditional means. Additionally, asset managers are offering increasingly popular multi-asset class funds of which ETFs comprise about half of the portfolios. These developments create opportunities to distribute ETFs to various institutional client segments.

The third trend relates to disruptive innovation. While there are several innovations we are watching, developments in the Digital Investment Advisory (robo-advisor) space are timely and relevant. It is important to note that Digital Investment Advisory also represents an emerging distribution channel. By leading with a value proposition that emphasizes technology, simplicity and low cost, upstart digital investment advisors are seeking to appeal to underserved segments such as younger investors. Without ties to legacy platforms, processes or technology they offer mass customized solutions that can be delivered at low marginal costs. Many digital advisors are heavy users of ETFs and have the potential to become an important distribution channel for ETF sponsors. The most notable developments in 2015 were among established financial firms. Several leading asset managers entered the digital investment advisory space via acquisition, strategic partnerships or de novo build.

Distribution is evolving, particularly through the leverage of technology and new challenges. As client demographics change, the way to acquire and retain them changes. This is occurring more rapidly than some people think. Our strategy involves constant evaluation and engagement with all distribution channels that align with our value proposition.

LOOKING FORWARD

As an ETF sponsor of choice, FlexShares leverages deep investment expertise, collaborative relationships with investing clients and a rich fiduciary culture to deliver distinctive ETFs. Our portfolio management capabilities in index management, quantitative research, fixed income, and multi-asset class solutions, provide a rich set of capabilities that enable innovative product. Our business principles and core values are the drivers of our investor-centric approach. In 2016, we will continue to provide innovative ETF solutions and unique investment insights that help you serve your clients.

FOR MORE INFORMATION We would be happy to answer any questions you may have about our concepts, processes and products. Don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383) or visit us here.

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