Trends Shaping The ETF Industry In 2014 And Beyond


After two decades of massive growth, the ETF industry's momentum may just be starting, PwC asserts. The market research firm forecasts the industry's assets under management will explode to $5 trillion from $1.7 trillion now in the next three to five years.

Bill Donahue, managing director at PwC, explains major trends shaping the industry's growth and its inevitable growing pains noted in the firm's report, "The Next Generation of ETFs."

IBD: To what do you attribute the widespread growth of ETFs?

Donahue: ETFs are attractive to individuals, intermediaries and institutional investors alike because of their key characteristics: liquidity, transparency, low cost, tax efficiency and intraday pricing.

Additionally, passively managed ETFs were well-suited for the increased scrutiny of costs and more widespread acceptance of indexing as a philosophy over the past few years. ETFs helped meet the demand for many investors for greater liquidity and transparency in the aftermath of the financial crisis.

The migration of U.S.-based investment advice toward a fee-based model has worked in the favor of ETFs, which provided investment advisers with a convenient and effective means of constructing customized client portfolios across a liquid and diverse series of asset classes.

ETFs offer a convenient way to adjust portfolio exposure on many fronts, including geography, market capitalization, industry sectors, credit quality and duration.

Over the past few years, there has also been significant product innovation for ETFs, with expansion into fixed income, commodity and balanced-asset classes, which have been very well received by investors. The recent introduction of ETF strategists who research, design and manage portfolios of ETFs has created expanded ETF offerings and contributed to the growth of ETFs.

Many ETF sponsors have expended significant efforts on investor education over the past few years, which have helped to generate further interest in their products. A number of online brokerages over the past few years started offering low-cost or commission-free trading, making it easier and less expensive to trade ETFs.

IBD: How did you come up with your forecast that ETF assets will grow to $5 trillion in the next three to five years?

Donahue: Global ETF assets under management total about $2.4 trillion currently. There are significant growth opportunities in a number of different areas over the next few years:

1. Move away from commissions on a global basis toward asset-based compensation, resulting in investment advisers focusing more on asset allocation rather than security selection, which should favor ETFs.

2. Opportunities for ETFs in the defined contribution markets.

3. Expanded opportunities for ETFs in Hong Kong and China once they have worked through a mutual recognition platform.

4. Further expansion of the U.S. active ETF market.

5. Expanded use of ETFs by both institutional and retail investors.

IBD: What inevitable growing pains will the industry face?

Donahue: As ETFs continue to grow, the current infrastructure and risk oversight mechanisms will be tested. While the mutual fund industry relies on an infrastructure that has proved resilient in a range of market and economic challenges, the ETF infrastructure is relatively new and is just now being tested with significant assets, both in the U.S. and globally.

While ETFs have been around for more than 20 years, there continues to be a lack of technical understanding of how they work and how they can be used as a part of an investment strategy. ETF sponsors will need to continue to focus on investor education, including thought leadership and content marketing to further the understanding of the technical details related to their ETF lineup.

IBD: What are the regulatory challenges ahead?

Donahue: ETFs have been extensively scrutinized by regulators for many years. While there has been some recent easing around the use of derivatives and self-indexing recently in the U.S., there continue to be regulatory challenges of one kind or another in almost every market around the world.

U.S. active ETFs have been around for a little more five years and have reached approximately $16 billion AUM (assets under management). The requirement to provide daily transparency of the active ETF portfolio holdings is likely affecting the development of active ETFs.

The SEC is also focusing on new and emerging risks for ETFs:

1. The growing use of alternative and hedge fund strategies.

2. Whether boards, compliance personnel and back-office functions are appropriately staffed and financed to cope with these strategies.

3. Compliance with exemptive relief orders and the use of custom baskets and compliance with regulations when marketing.

ETFs in Europe and Asia trade and settle on a national basis. The resulting inefficiencies increase the cost of ETFs.

However, in both Europe and Asia, recent developments may potentially reduce trading frictions and improve liquidity and reduce the costs of trading ETFs.

Hong Kong and China regulators continue to work on the details for a mutual recognition platform for public funds to be sold directly in each market.

These two jurisdictions have different trust laws, fund distribution regulations and post-sale servicing practices, which have to be aligned prior to the launch of the mutual recognition platform.

IBD: What do you see as the biggest trends shaping the industry?

Donahue: 1. Continued expansion of the ETF strategists.

2. More focus on solutions-oriented ETFs, including fixed income and active funds.

3. Upcoming regulatory and policy changes likely boosting the distribution of ETFs in Europe and Asia.

4. Significant growth for active ETFs.

5. Continued focus on investor education and distribution strategies.

6. Global expansion of ETF sponsors in pursuit of growth and scale.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , ETFs

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