Last year, after the 2018 Inside ETF conference, I discussed some incredibly fierce competition and the fact that there were 1,000 ETFs with less than $50 million in assets. I asked how many funds would survive the coming years in an increasingly commoditized market and predicted that we would see a larger number of fund closures in 2018, a prediction that has in fact been borne out by 155 fund closures in 2018 versus 135 in 2017. Well, it’s not often that I return from a conference with the distinct sense that a sea change may be upon us, but that is exactly how I feel as I reflect upon the annual Inside ETF conference held in Florida just a few weeks ago.
Sources: Morningstar and ETF.com
Although most of the ETF professionals were enjoying the warm weather, there was still a slight chill in the air. Many of those present have enjoyed being on the right side of a trade that has seen hundreds of billions of dollars move from high cost active mutual funds to low cost passive index mutual funds and ETFs, but we’re at an inflection point and I am increasingly confident that this is recognized. As I looked around the large exhibition hall, I couldn’t help but notice that the vast majority of assets continue to be represented by just a handful of players, which made me speculate that in years to come there would be fewer exhibitors. Yes, some funds are gathering assets, but this is often on the back of something we in the industry call BYOA or Bring Your Own Assets. Unfortunately, these new funds are usually forced to price themselves quite aggressively in order to justify moving billions of dollars of proprietary assets to your own, newly launched ETF and to avoid the accusation that there is a cheaper competitor just down the block. Much of this is clearly illustrated in a recent blog post, Tough Times for New ETF Launches, by FactSet’s Elisabeth Kashner, CFA, which shows how hard it is for a firm to go from launch to profit making success. This realization is starting to sink in amongst industry professionals.
More broadly, fees and margins have compressed across the ETF industry so much that increasingly they enable only the largest scale players to be profitable. For example, on February 26th, Vanguard disclosed in regulatory filing that it is cutting fees on 10 ETFs that invest primarily in international equities and fixed income instruments. Also, while the so-called Race to Zero may be slowing when it comes to management fees (you can only go so low before you are no longer a profit making enterprise) the number of ETFs that can be traded on a commission free basis continues to grow at major distributors such as Charles Schwab and Fidelity. Depending on your perspective, this can be a good thing or a bad thing, but the reality is that the average investor is benefitting from these cuts. According to a recent article in The New York Times, An Unlikely Effect of Jack Bogle’s Creation: Helping to Keep Inflation Low, the cuts are having a measurable and deflationary impact on inflation as measured by the Personal Consumption Expenditures index.
One might ask where this all ends, but fortunately, Dave Nadig and Matt Hougan (Inside ETFs) stirred things up with a keynote presentation entitled Direct Indexing – The Great Unwrapping. This is something we are beginning to cover. Though still young, direct indexing may be a potential disruptor, and product and distribution professionals at both asset managers and wealth management distributors should be following it closely. We have moved into an era in which the consumer wants customization and technology. It is becoming exponentially easier to provide personalized portfolios to high-new-worth investors and households in ways that would have been much more difficult and expensive only a few years ago - a Separately Managed Account (SMA) Version 2.0. Mutual funds and ETFs are not going away any time soon, but much of the way ETFs disrupted mutual funds by being easy to use, transparent and tax efficient, direct indexing, or some iteration of it, may be the mousetrap that financial advisors and their clients are looking for.
Written by Michael Andrews, CFA
Head of Investment Products Research & Consulting