Several weeks ago, I spent a few days in Florida at the annual Inside ETF conference. Besides spending a great deal of time listening to a wide variety of presentations on subjects ranging from when we will have our first Bitcoin ETF (perhaps never) to the development of factor-based Fixed Income ETFs (watch out active fixed income managers!), I also had the opportunity to wander the exhibition hall.
While I was struck by the creativity and innovation of an industry that has created an ETF for what seems to be all investment needs, I left wondering how many of these funds will survive the coming years and fierce competition in an increasingly commoditized ETF market. When one fund (SPY) has in excess of $300 billion of assets, 30 ETFs control more than 50% of industry AUM, and three firms essentially dominate the US ETF marketplace, it is natural to ask what is going to happen to the 1,000 or so ETFs that each have less than $50 million in assets.
Source: Morningstar Data, Q4 2017
If you believe, as I and many of my colleagues do, that the investment management industry is experiencing a perfect storm due to the effects of innovative technology, demographic change, and fee pressure, the odds are that many funds, too many of which are already “zombie” funds, will be closed or sold off to a firm that has the scale and resources to create better economic value for the funds’ investors and their sponsors. We may be starting to see the beginnings of what could be some interesting M&A activity in 2018. The bottom line though – with certain exceptions such as factor-based fixed-income ETFs where product development is just beginning – is that the ETF industry appears to be moving towards a saturation point where big low-cost funds with distribution grow larger and smaller funds struggle in an environment characterized by low volume, relatively large bid/ask spreads, and low AUM.
All of this being said, however, there remains one area where I believe the industry is likely to see a great deal of activity in the coming year. Notably, I am hopeful that the industry will finally be able to choose which solution will work best to make actively-managed, non-transparent strategies available in an ETF or ETF type structure.
Our recent Product Strategy Compass article published in November 2017, “The Exchange Traded Product Update: New Times, New Products, New Opportunities” reviewed the current state of the active, non-transparent ETF market. The article paid particular attention to the innovative pre-packaged solutions put forward by Eaton Vance’s NextShares™, Precidian’s ActiveShares℠, and Blue Tractor’s Shielded Alpha℠, as well as solutions from Fidelity, Vanguard, and T. Rowe Price. The NextShares structure is a hybrid of both a mutual fund and ETF technically speaking. Unlike traditional ETFs, the product’s purchases and redemptions are made based on the next-determined NAV. Several leading asset managers have entered into licensing arrangements and have launched funds. To date, assets are limited and distributors appear reluctant to make the necessary operational changes to accommodate the somewhat unique structure. Precidian’s ActiveShares seem better suited from an operational perspective. Despite the backing of several large asset managers however, they have been unable to secure regulatory approval as a result of concerns surrounding their possible vulnerability to front-running and replication.
I am eager to see a head-to-head competition, and am hopeful the SEC’s Division of Investment Management will approve Precidian’s most recent restated application filed in December 2017. It is my view that for some active management firms these active ETF innovations have merit and are worth tracking. While active, non-transparent ETFs are not likely to relieve downward fee and revenue pressures, they could provide opportunity for some firms, especially in a world in which financial advisors are vehicle agnostic. Nonetheless it will ultimately be up to the market to determine whether one of these new active, non-transparent solutions is a better mousetrap. In any event, the game has changed and managers will have to be mindful of consumer preferences regarding price, value, and performance. Providers will need to articulate what their product is, the benefits of non-transparency, and what needs it serves.
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