The ETF industry is growing by leaps and bounds. New entrants and products appear almost every week, assets are on the rise and many of the unique features of ETFs including transparency and efficiency are in demand. Yet with all this growth comes a variety of challenges for the industry. Here are three I would like to highlight.
The ETF industry is certainly a big tent. There are ETFs structured in a variety of ways including traditional 1940 Act funds, non traditional leveraged and inverse 1940 Act funds, unit trusts, commodity pools and grantor trusts. Many of these different underlying ETF structures produce unique tax consequences, risks and outcomes. Consequently the term “ETF” has lost much of its meaning to many investors.
The ETF industry would be wise to recast itself as a broader group — Exchange Traded Products (ETPs) perhaps — and then define and standardize criteria and naming conventions for each type of underlying structure known today as an ETF. For an industry built around the concept of transparency, this seems like a logical choice to be proactive about. Ignoring it risks the quality of investor experience with ETFs and may invite regulators to create their own standardization.
The great news for investors is that ETF price competition is alive an well. Vanguard and even iShares have deployed successful price point campaigns against market leading ETFs. While investors benefit the ETF industry is in a revenue crunch. Besides diminished pricing power, more brokerage firms are now seeking to gather revenue from ETF sponsors that has been lost by declining mutual fund sales. Product approval blockages, lack of ownership data and service agreements are beginning to crop up at brokerage firms as a way to get ETF Sponsors into the traditional “pay to play” mutual fund model.
If that pressure was not great enough, broker dealers like Schwab, Scottrade and Vanguard are tightening the belt by offering free ETF trading for account holders in proprietary ETFs. The advantage of having the economics of an execution business combined with an ETF product line puts more pressure on firms that are not broker dealers. Indeed, we have already seen several broker dealers without ETF lineups begin to offer free trades in selected ETFs from selected ETF Sponsors. This leads to more revenue compression on ETF Sponsors and should increase ETF closures and ETF company acquisitions going forward.
ETFs have still not made a dent in the significant amount of existing defined contribution assets or inflows. This space continues to be dominated by mutual fund offerings. ETFs must begin to get on the menu of DC plans as their inflows are consistent and massive. While ETFs may not be as attractive in a non taxable entity, it is no doubt an opportunity to not just grow assets and but increase awareness of ETFs. Remember millions of Americans are only familiar with the types of investments found in their DC plans. By simply becoming a widespread DC plan option, ETFs would achieve a significant victory.
Finally, the indexing based roots of ETFs are strong and will continue to be the lifeblood of ETFs. However, with active mutual funds dominating mutual fund investor assets, actively managed ETF offerings need to increase in order to bridge the gap between the ETF industry and the mainstream investor. As we have learned from the mutual fund industry, most investors will always prefer active management. To ignore that large group of investors is to walk away from an opportunity to showcase the transparency, efficiency and flexibility of the ETF structure. The ETF industry will become healthier and more diverse through a robust effort to capture active assets. It will also be doing investors committed to active management a much needed service.
These three challenges are just several the ETF industry is grappling with. The good news is that what some would call “problems” are really “elegant problems,” meaning problems caused due to size and speed of growth of the ETF industry, not decline.