Trends that will shape the ETF market
Few doubt that ETF use will grow in the years ahead. Three out of four participants in a recent PwC survey believe the market will at least double by 2020 to US$5trn (€4.4trn)1. BlackRock believes European ETFs will reach US$1trn a year earlier, in 2019.
This article puts some more detail on what the instruments themselves will look like, who will be servicing them and who will be selling them.
Gazing five years into the future, it seems very likely that there will be consolidation of both providers and products. On sale in Europe today there are more than 20 versions of the S&P500 and more than 15 EURO STOXX 50 ETFs to choose from. These numbers do not account for the separate listings on different European stock exchanges, which can reach double figures for the most popular ETFs (the average is just over three listings per fund).
The market is oversupplied in both dimensions and for now the trend is for more providers to make a splash. Last year Goldman Sachs Asset Management entered the fray and JP Morgan Asset Management the year before. Firms such as BMO, not known for passive management, offer ETFs.
The rise of smart beta has only exacerbated the situation, tempting both large and small houses with quant capabilities into issuing ETFs. Just as there are too many S&P500 ETFs, so there are, arguably, already too many smart beta ETFs.
But by 2020 oversupply in all investment categories and countries ought to have shrunk in line with market forces. Many of the 50-odd ETF issuers in Europe are not sufficiently profitable; some have been touting themselves for sale for over a year. Market leaders will sweep up the more attractive lesser players while the rest fall off the distributors’ platforms.
Those platforms will change not only because of product and provider consolidation. Regulators in various European countries, notably the UK and Switzerland, are bearing down on distributors’ fat margins. The days of retrocessions seem numbered and that has consequences for both the platforms and providers. If both have to slim down then the impetus to manage and market more complicated active products, notably multi-asset strategies, is blunted. There will always be higher-value products such as absolute return. But there are efforts to clone even hedge funds via passive products, which means ETFs and other passive products are going to have a bigger presence on distributors’ platforms.
This explains in part the expected growth of ETF assets under management. But it also has distinct consequences for distributors. They are going to have to offer more advice to maintain revenue streams and hold on to clients in the absence of retrocessions. Offering advice on passive products sounds a lot like robo-advisory, and given the market share of Europe’s distributors, this could spell bad news for the robo-advisory start-ups. Yes, the latter have great technology but investments are not like taxis or hotel rooms. The distributors and major global platforms such as Charles Schwab are likely to appropriate robo-advisory models for themselves and leave the remaining independent start-ups to starve.
Technology’s influence will not be restricted to the link with clients via their computer or tablet screens. Bigger providers may well combine fintech know-how with their own muscle to knock out some of the other links in the current chain of ETF operational management. Possibilities for displacement – or at least replacement – include brokers, index providers, fund administrators and weaker distributors. The tantalising question is whether a giant from the tech sector, as opposed to a start-up, fancies becoming the disruptor here.
The argument comes back to the salient truth about investments. The irony is that tech giants like Google are so concerned by antitrust and monopoly allegations in their current domains that invading another sector might prove more troublesome than it is worth. Asset managers would never dream of owning more than 5% of the market; that is not the Silicon Valley model, which is why the crossover might not take place.
Despite expected growth, are there any dangers ahead? For ETFs as a type of instrument, few are imminent. Platform-traded funds have launched in Canada but so far that is from one provider in one country. Innovative, laudable, but small. More likely is reputational risk for the whole industry should further market turbulence land some of the more illiquid types of ETF in trouble. Leveraged loans take weeks to settle. This feature is apparent in a closed-end arrangement.
But the modern fashion is for tradeability and open-endedness. A sharp downturn in liquidity could have ramifications not merely for the instruments involved but the reputation of ETFs. Of course a blow-up could also occur in the mutual fund market. But even in high-yield credit ETFs only account for 2.6% of the total market. So illiquidity is a problem for UCITs in general, not just ETFs.
In any case, there remains a lot of good news for the ETF providers that remain in five years’ time. The dull but likeliest prediction about ETFs is that they have a lot of potential to fulfil.
1. Consolidation, not proliferation
The asset management industry has stubbornly refused to consolidate at the pace of other sectors such as cars and phones – perhaps because its ultimate product is trust, which is not easily commoditised or mechanised. Then there is the tendency for diversification: not the oft-talked-of investment diversification but product diversification. It helps keep businesses flourishing. As the ETF sector grows, asset managers, investment banks and independents see an opportunity to diversify their revenue streams. Recent entrants include Goldman Sachs Asset Management.
So if everyone jumps on the bandwagon, why should we expect consolidation rather than proliferation in the years ahead? Because ETFs are relatively new, local market leaders have not had much time to build their business free of global competition and passive has always been a volume game compared to active management. The top three houses globally for ETFs – iShares, Vanguard and SPDRs – have almost 69% of the market, according to ETFGI. Most rivals wishing to diversify face the struggle of going from active management to passive. Smart beta is an unusual gift here because it gives newcomers a chance to charge higher fees despite the systematic nature of the product. But smart beta is away from the main battlefield of a price war in which the biggest players can afford to bleed for longest. Not only has the symbolic 10bps management fee threshold been passed on mainstream products, smaller houses such as Source are offering bargains such as the EURO STOXX 50 at 5bps.
Edgar Senior is former head of product at Source and now an independent consultant. He believes there will be far less dispersion in management fees by 2020: gone will be the ultra-low fees but also high-end fees, like 45bps for emerging market equity ETFs. Senior’s prediction of standardisation also extends to product providers. While he expects Europe’s mega houses to survive – “Deutsche Bank will always be there” – he expects considerable merger activity at every level below. Looking at the length of the tail of providers, it seems a sensible rather than a startling prediction.
BlackRock, the market leader, agrees that there is little room for fees to go much lower and also predicts just two types of provider in the future. “The first are the larger players who can offer a product range covering the full breadth of markets and asset classes, and the second are niche players who have a sweet spot in a particular asset class,” says Rachel Lord, head of EMEA iShares at BlackRock. “This bell-bar shift will leave the mid-sized players stuck in the middle and may result in many being squeezed out of the market.”
On the other hand, it has been almost three years since BlackRock took on Credit Suisse’s ETF business in Switzerland. Since then there have been few deals but a relatively smooth appreciation of equity markets. This cannot be mere coincidence and other providers see more room for others.
“There may be consolidation where the bigger players make talent acquisitions,” says Bryon Lake, head of EMEA at PowerShares, the world’s fourth-largest provider. “But in the long tail there are several players that are a division of a large investment bank or asset manager that will limp along only because of their belief in the ETF market’s potential in the years ahead.”
While passive is a bulk business, Lake interprets that as an advantage. “Once you start building scale, you don’t need to worry about liquidity or hiring more portfolio analysts the way an active product requires,” he says.
Bruno Poulin, president of Ossiam, a smart beta ETF provider, believes that consolidation will take place in product ranges, leading to higher average ETF fund volumes and the winners taking a greater share.
What about the trend for smart beta itself? No surprise that Poulin believes that here providers will proliferate by 2020 (there are already more than 20 houses in this field in Europe).
Senior points out that smart beta providers are currently selling backtests. By 2020 the current vintage will all have a five-year track record. Dimitris Melas, head of research at MSCI, and others have long warned that individual risk factor premia can deliver negative returns for long periods. Senior reckons that investors will be able to make much more informed decisions in five years’ time.
2. Robo-advisers: the future is already here
In the 1990s science fiction writer William Gibson posited that the “future is already here, it’s just not very evenly distributed”. The comment can be applied to ETF trends as distributors gradually lose their grip and are forced towards cheaper product ranges or advisory services. Swiss private banks are still coming to terms with the loss of their practice of retrocessions, part of a bountiful set of expenses between asset manager and platform that could take 5% of a client’s wealth before it was properly invested. In the UK and the Netherlands, financial advisers can no longer take remuneration as a percentage. They have to get used to fee-based services rather than trail commissions.
Bad news for the old guard but good news for robo-advisers, currently patchily represented across Europe but no doubt part of the future. These start-ups use smart technology to remember and build on clients’ preferences. They are also nifty at applying behaviourial psychology such as nudging to help investors make investment decisions. But they also tend to be top-down, which means using a lot of ETFs to execute asset and sector allocation decisions. ETFs trump funds here because the former are easier to buy and sell.
Many pension fund and employee benefits executives won’t see robo-advisers as particularly new. The technology is fresh but the investment concepts are not dissimilar to simple DC choices such as target-date funds. Moreover, there is a whiff of concern that because of the strong association between ETFs and robo-advisers, any fiasco or rotten performance by one of the latter could taint the former.
“It’s great that these guys are using lots of ETFs but at the same time I am cautious,” says Manooj Mistry, head of db X-trackers in London. “I need to see a proven track record for three and five years before I am convinced they are adding alpha.”
Poulin says that the distributors will improve their digital experience to outcompete the newcomers. BlackRock bought FutureAdvisor last year before it reached $1bn under management. Early this year, Invesco acquired Jemstep, whose robo programmes can be white-labelled to distributors. For Poulin, the better digital experience means retail investors will be more savvy about their investments. But because of the distributors’ continuing grip, he predicts lower retail growth of ETFs in Europe than current expectation. In other words, the distributors have not entirely changed their spots and will push higher-margin products where they can.
3. Fewer links in the ETF value chain
Buying out a start-up robo-adviser hardly counts as knocking out a link in the chain, although it should spell cost-savings on in-house portfolio researchers and client relationship managers if the algorithms work. Improving the digital experience, including the interface with clients, could, however, represent a first step in shortening the whole chain of ETF operations. The first links to disappear would be the least effective distributors, pushed aside by stronger distributors and ETF providers finally ready for a direct relationship with retail clients and with the right kind of website tools to achieve this.
One long overdue tool fintech is bringing fast to asset management is snappier branding. Motif is a US start-up that enables customers to invest in thematic portfolios of up to 30 stocks. Nothing very new there, except the concept is cheap and cheerful in a way mainstream financial services have yet to understand: the range of themes spans the financial – energy, healthcare and real estate – but also the social and political – battling cancer, cleantech everywhere, pet passion and Republican donors are among the themes available. Motif might not survive until 2020 but its snappier branding should help in shifting the industry towards consumerism.
Mainstream index providers might also be under threat. Vanguard rattled the industry four years ago when it moved 22 funds from MSCI to FTSE. But a more profound change would be foregoing an established provider altogether in favour of a proprietary methodology. Goldman Sachs Asset Management’s ActiveBeta range is benchmarked against GoldmanSachsActiveBeta indices – the only difference in each case comes from costs.
Mistry says his unit has created some such ETFs for private banks: “I wouldn’t be surprised if we see more of this. Many clients just want exposure to the underlying market or asset class and are not worried about the brand of the index.”
But investment banks are past masters at creating indices to package ideas and facilitate trading. Power-Shares’ Lake does not see the advantage: “We treat index providers as partners rather than service providers. They do a great job educating clients and bridging academic ideas with investors’ needs.”
Senior suggests that by 2020 one tech giant or another could move into asset management in such a way that it takes away the role of the broker and several mid-office functions. “A Google could let you hit a button on your customised Google homepage that gets you the stock exposure you want,” he says. But the hypothesis is that Google would be operating a dark pool, including matching of buyers and sellers around the world.
Senior hastily adds he does not expect Google to be the one to do this. His point is that with the right scale and technology, a firm can settle buying and selling between clients internally. It already happens but not on a titanic scale.
Meanwhile, a much more prosaic revolution has started within the back office. Euroclear has created an internationally settled ETF structure to improve the woefully low levels of stock lending in European-listed ETFs. Just as spreads to buy and sell ETFs in Europe are multiples of comparable US spreads, so traders are reluctant to pay 250–300 bps to borrow stock.
Mohamed M’Rabti, deputy head of global capital markets at Euroclear, says the initiative – and a similar project by Markit to list ETFs by their worthiness for collateral – will chip away at those lending spreads.
This is an earnest rather than a dazzling prediction for 2020 – currently less than 1% of Europe’s ETFs are in this international structure. But the initiative is only two years old and all new ETFs from iShares, the dominant provider, will be listed in this format. In the absence of a Google dark pool or the European Commission’s plan for a Capital Markets Union, the Euroclear initiative may be one of those well-thought-out incremental changes that make greater difference than more spectacular predictions.
1 ETF 2020, Preparing for a new horizon, PwC