Is it time for ETF Innovation to Shift from Products to Product Distribution?

The ETF industry is celebrating its latest impressive innovation: The non-transparent active ETF structure. The concept is so novel and has so many applications that the providers lined up to offer this product have not yet standardized the name for them. They have been referred to as non-transparent or semi-transparent, actively managed ETFs; active shares; and even ANTS (Active Non-Transparent ETFs). Whatever you call them, celebration is well-deserved because of the five plus year regulatory slog that it took to obtain SEC approval of this product.

Certainly, there is a strong possibility that the roll out of the non-transparent active ETF structure will be the next major milestone in the ETF industry. But what may be even more significant is the absence of the 28 year old ETF industry chatter about the next great product innovation. Has the ETF product run its course in terms of innovation similar to the mutual fund, closed-end fund and unit investment trust?

The lack of next blockbuster ETF product should not be viewed as a negative, but rather a reality. In fact, it is likely healthier for the industry to pivot from trying to develop the next newfangled ETF product to pouring its energy and resources into figuring out how existing ETF products can better be distributed to and used by investors. Much like many maturing industries, innovation naturally will shift from production to distribution. For ETFs, innovation on the distribution front is long overdue as the ETF industry has struggled to replicate the historic mutual fund distribution model that still successfully relies upon charging the investor a purchase price (i.e., a load) for mutual fund shares and dipping into the mutual fund’s actual assets (via a Rule 12b-1 fee) to incentivized financial intermediaries to sell fund shares. Because ETF shares trade on exchanges, this model is not available to ETF providers and they are left with reaching into their own pocket to use legitimate profits from the advisory fee to compensate intermediaries who sell shares of their ETF shares. Furthermore, it is often difficult for the ETF provider to know who to pay. On the one hand, mutual fund shareholder accounts are often held directly at the fund’s transfer agent and since these shareholders are easily identifiable, they become customers who receive direct marketing from the fund provider. ETF providers on the other hand remain in the dark about who their shareholders are, making it difficult for such shareholders to morph into their customers.

As products based on the non-transparent active ETF structure gain regulatory approval and begin to launch, the ETF industry must innovate ways to distribute these and traditional ETF products. Such innovation is especially critical for small- and mid-sized ETF sponsors that swim in the same ecosystem as three goliath ETF providers that have garnered over 80% of ETF assets under management. If a firm is not one of these goliaths, it must further contend with the fact that the best avenue for distribution leads to a handful of brokerage firms control the largest ETF distribution platforms, all with close ties to the goliaths. 

ETF BILD’s outlook for 2020 showcases the opportunity to identify the ETF distribution challenges and stimulating ideas, and thoughtful approaches to how best the lineup of ETF products can be distributed, especially by the small- and mid-sized ETF providers. New technologies, interface demands from Gen Xs, Ys and Zs and other trends may be indicators to what types of distribution innovations are necessary to ensure that ETFs, in whatever shape and form, continue to thrive.

As ETF BILD remains devoted to providing education to the industry, its founders will continue to seek out the knowledge and experience of thought leaders, providing an engaging platform to share their views and ideas. Comments are welcomed below, should you be interested in sharing your thoughts on this topic.

A Guide for Inside ETFs

The annual trek to sunny South Florida is once again upon the ETF industry; a time to reflect, prognosticate and network with our colleagues at the Inside ETFs Conference. It is an interesting time in the industry; change continues to be the only constant, but it feels like it is developing more rapidly these days. Recent regulatory rulings, fee announcements, consolidation, assets flowing into fixed income products, and perhaps fundamental shifts in operational strategies can all pose challenges for the industry in the coming year.

The big three ETF providers remain in complete control of the assets in the industry but there continues to be sizeable pockets of opportunity for the more niche players. As assets continue to flow into ETFs, there remains a significant amount of revenue opportunity in the not fully developed areas such as the alternative/thematic investment themes.

Issuers need to adapt to take advantage of the many opportunities the changes will bring as they come into focus in 2020. These include the use of technology, applying regulatory easing to their advantage, investors’ need for performance driven products in a changing market environment, and reaching distribution channels digitally to name a few.

The Inside ETFs Conference will showcase many of these points during the impressive panel discussions featuring prominent speakers. However, it’s the conversations in the hallways, at the dinner tables, the cocktail hours, and of course, the hotel pool cabanas that may be more informative.

We anticipate the following to be key topics discussed inside and outside the conference that will influence the decisions we make as industry professionals.

   ETF BILD welcomes all comments and suggestions.

ETF BILD Represented at Industry Conference

At ETF Global’s fall ETP Forum, co-founders John Jacobs and Bibb Strench participated in a panel discussion on regulatory, industry and legal issues in the ETF industry. The discussion included developments surrounding product approval process, custom baskets, nontransparent ETFs, and the SEC’s “ETF Rule.”

ETP Forum is a comprehensive one day program that has been built upon the premise of allowing Advisors & Institutions the opportunity to take a deep dive into the most relevant investment themes this year. ETF Global  (ETFG®) is a leading, independent provider of data, research, investment decision support applications, proprietary risk analytics and investment models for Exchange-Traded-Products.

A full look at the ETF Changing Legal & Compliance Landscape Panel can be found here:

ETF BILD Participates in Thompson Hine ETF & Alts Conference

ETF BILD Co-Founders Bibb Strench, John Jacobs, Richard Keary, and Justin Meise discussed converting mutual funds to ETFs and its implication on the industry at the Thompson Hine ETF & Alts Conference in New York City on September 18, 2019.

Other conference participants included NYSE, Natixis, JMP Securities, CBOE, and FS Investments.

Regulatory, Operational Headwinds Slowing But Not Stopping ETF Innovation

The recent conversation from the SEC referencing the competitiveness of the ETF industry points a finger at some of the challenges the industry faces but there remains plenty of opportunity. The large firms have scale, thus access to larger concentration of AUM; however, the smaller players have the entrepreneurial spirit and the strength of innovation, which built this industry and continues to live in its DNA. Innovation will keep the upstart ETF managers in this business and give them the potential to thrive.

Interesting products continue to come to the market exploring such investment opportunities as space, crypto, blockchain, robotics, clean energy and others. Advancements in index creation technology are building efficiencies and refinement in the production of dynamic indexes, long/shorts, multi-asset, multi-factor and other innovative strategies. The process in which a manager can launch an ETF today as compared to 5 years is much faster and cheaper.

But product differentiation by itself will not attract assets. Seed capital and distribution continue to haunt these nascent ETF managers in growing AUM.  Finding solutions for these problems plagues the industry. The solutions will not come from the larger ETF providers, but from the nimbler and more inspired firms. They must find a way or languish with missed opportunities.

The SEC Division of Investment Management’s approval of Precidian’s ActiveShares and expected approval of additional non-transparent actively managed structures, should open additional doors of opportunity by making available a product that combines mutual fund actively managed capability with ETF tax efficiencies; in other words, a killer app.  These long-anticipated products will bring new users and issuers to the ETF market.  It won’t be an overnight success but a platform to continue to provide solutions for investors.

Another concept that may occur soon when certain regulatory and operational issues are solved is the conversions of Mutual Funds to ETFs. This is a significant opportunity for the ETF industry; a potential game changer, especially when combined with actively-managed, non-transparent ETFs. ETF BILD is taking a deeper look at this development and will provide an in-depth analysis in upcoming content pieces.

Despite all these exciting industry developments the structural challenges that the SEC is investigating still exist. Market structure for low liquidity products, costs and approval process for access to wire-house distribution channels, systemic risks of concentration in custodians and indexers and seed capital to name a few that need to be addressed.

ETF BILD applauds the SEC’s initiatives, including its new outreach initiative targeted at small and mid-sized mutual fund and ETF sponsors. We believe strongly that the smaller and mid-sized ETF providers need a voice in SEC/FINRA rule making process for ETFs. We are also aware of the challenges of having a government regulatory organization interfere in the competitive landscape of an industry. The big ETF providers (iShares, Vanguard, State Street) built this industry and thus have first mover advantage and were the first to build scale into their operations. They should not be punished for that but there also needs to be a proper environment for growth.

Innovation does not just come in the form of new investing themes but in looking at the challenges the industry faces and to find the solutions the industry needs to keep creating opportunities. There are solutions for these challenges, but they won’t all be discovered by the large ETF providers without the input of the more inventive, entrepreneurial and innovative ETF industry participants.  Those whose businesses are in jeopardy because of the challenges of raising AUM.

Changes to the ETF industry either through regulation or in best practices can ensure that growth opportunities for small and mid-sized fund companies exist is a critical discussion. We welcome all comments and policy suggestions from our readers.

Direct Indexing: ETFs — Friend or Foe

April 2019

Since 2014, direct indexing has been thought of as a potential threat over the ETF industry, but only recently has it become more prevalent. Direct indexing has many advantages that have come to the forefront in recent years: enhancements in portfolio construction, tax harvesting and the demand for passive products. Though these are not new ideas, reduction in transaction costs and technology advancements in creating and customizing indexes have led to the cost and operational efficiencies that have produced an increased focus on these products.

The main difference between direct indexing and index funds is that the investors own the underlying shares. This gives them the advantage to take tax losses on underperforming securities in the portfolio. The overall tax advantage of that process versus the tax advantages of ETFs can be argued, but the results might be negligible. However, that tax advantage versus a mutual fund can be as significant as the advantages of ETFs versus mutual funds.

The advances in technology have simplified the direct indexing process. Creating indexes on Excel has been transported to more systemic processes, yielding more sophistication to product development. There have also been operational improvements in delivering trading instructions and rebalancing data.

Direct indexing has become the next disruptive product in the financial services industry. There have been many discussions about innovation in ETFs and the potential loss of it because the industry is so tied to just three firms — iShares, Vanguard and State Street. Maybe direct indexing is not about ETFs but an additional delivery mechanism to provide investors with the access to passive investment strategies. It is also being seen by traditional ETF providers and indexers as a potential new distribution channel.

There will always be investors who do not want to use ETFs for various reasons and may be willing to pay higher fees to have more control of their portfolio or let their trusted advisor have more access through direct indexing. Thus, this new disruptive process might be more of a threat to active mangers than to passive. They carry the same performance risk as an active manager because of potential tax loss, selling at the wrong time and customizing the portfolio by using a smaller sample of securities than the benchmark.

Direct indexing could also become a boon for ETFs. If direct investing is reaching RIAs who are moving out of actively managed products and their first move to passive is direct indexing, then their next move might be into ETFs. There are still large numbers of RIAs who are not well educated in ETFs, but direct indexing may be the vehicle that strikes their curiosity and eventually pushes them into ETFs. Fee structure could be that trigger point. ETFs are still significantly less than a traditional SMA or direct indexing account.

One group that is all in on the direct indexing craze is the indexers themselves. Fees paid to indexers on direct indexing platforms are more robust than what they are receiving from licensing an index to an ETF provider. The challenge is the depth of indexes on these platforms and how to differentiate your index from others. Brand is less of a differentiator, and index construction is highly vetted by the advisors using these platforms. Performance matters.

Direct indexing is the new disruptive process circling the ETF industry, but it just may be more friend than foe.

Lack of Education, Demand for Alternative Strategies & More: The Next Big Trends in the ETF Industry

March 13, 2019

All signs point to the ETF industry searching for its next pivot point. To kick us off in 2018, we saw the continued trajectory toward new equity index ETF products first led by the roll-out of blockchain ETFs. However, this year seems to signal something entirely different as there has been little to no fanfare about new ETF products entering the space. Chatter in the industry has revolved primarily around deals between small ETF issuers and the absence of, or less show of strength by, large ETF issuers. Consolidation and slowing product innovation have been the bellwether signaling the maturity of many industries. Nevertheless, that may not be the case in this industry as recent off-the-record conversations amongst industry participants have centered around new ideas that are being developed by niche players funded by private equity. As seen in February at the annual Inside ETFs conference, the ETF industry seems to have refueled from its long upward journey in 2018 and is preparing to pivot towards a new trajectory that, nonetheless, is still pointed upwards.

Over recent months, several interesting trends have come to light such as the increase in demand for alternative strategies. The shift in the risk profile of the markets that occurred last October is still on the minds of advisors. They have also become more comfortable with these complex strategies. However, the challenge remains to tailor the pitch for these products as simple sells.

Education continues to rise as a hot topic. As much as we as industry professionals feel that ETFs have become increasingly more mainstream, an education void still persists. The existing RIA channel provides limited education; however, it is just too broad with its one-size-fits-all approach to be the optimum education solution. The RIA channel also is inundated with ETF wholesalers from a wide variety of issuers who tell different stories about ETFs. There are many independent advisors who are being reached on a very limited basis or not at all.

Turning to new players in the ETF industry, distribution and access to seed capital remain the biggest barriers to entry for the ETF market. New ETF managers with a single strategy continue to use social media as an outreach platform, which may be good for branding, but it has not proven to be an effective way for raising AUM. A more coordinated strategy including website, digital advertising and research content that all connect in a cohesive structure remains key. Raising capital to launch is one thing, but having capital for marketing and the ability to stretch that capital for a few years until assets roll is an oft-overlooked component to success.

New and small ETF issuers continue to look at increasing the likelihood of success in their launches by attracting a larger amount of seed capital. However, seed capital remains allusive. The days of having just a good idea and then launching it as an ETF are over. Lead market makers need to see a well thought out and executable distribution plan before even thinking about allocating basic seed capital. Having access to a dedicated sales force and the proper budget to support it will help in that process.

Larger asset managers and insurance companies are beginning to enter the ETF market. They have the brand, access to capital and the sales force needed to be successful. Leaders in the space have recently noted that actively managed, transparent ETFs — especially fixed income ETFs — are gaining steam and are a great way for asset managers to get involved in ETFs while bypassing the passive argument. Non-transparent, actively managed ETFs are apparently also on their way, as there has been discussion that is perhaps more hopeful than based on fact, with the SEC’s approval coming sooner rather than later.

The growth trajectory of the ETF industry continues its upward movement. Demand for new strategies; well capitalized and experienced new entrants; new structures like non-transparent, actively managed ETFs and a larger RIA audience in need of education are all making contributions to the continued rise of the ETF industry. 

Market Volatility

February 1, 2019

Speed of Information – Not ETFs, Algos or HFT

Why when the markets go down or become volatile do people blame ETFs, algorithms and HFT (high-frequency trading) when the real, and perhaps less obvious, culprit is speed of information?

Maybe it is human nature to build up success stories – ETFs – only to tear them down or to attack new technologies like algos and HFT that many people are familiar with but don’t actually understand or have access to.

The recent market volatility is nothing new. We have seen volatility spike in a variety of different markets over the years for various reasons. The market sell-off that started in October is not unusual given that the bull market has been long in the tooth but with relatively stable economic indicators and thoughts of a Fed Chairman being fired. Uncertainty is and will always be the Achilles heel of the markets.

The current market rally started in March of 2009 and has risen close to 300%, but even a healthy market needs to take a breath. It’s been a great, historic run. Maybe so much concern exists because so many of the people involved in the markets today have never witnessed a bear market. They lack a baseline for guidance and thus have a fear of the unknown.

There are real reasons for the markets moving the way they do, and they have always moved that way even before the proliferation of ETFs. While some of the largest ETFs track markets, they are merely access vehicles that provide investors with exposure to the markets and various asset classes. ETFs are not their own asset class. ETFs are not down, the markets are down. They merely reflect that move; they are not the cause.

ETFs help calm market volatility since they can be bought and sold throughout the trading day. This levels volatility as ETF investors can more readily access the market. However, this is very different for mutual funds. Mutual funds are priced only once a day at the 4:00 p.m. NAV price so when you sell your ETF at 10:00 a.m., you receive the 10:00 a.m. price. When you sell your mutual fund at 10:00 a.m., you must wait until the end of the trading day and will receive the 4:00 p.m. price. Markets can move dramatically between 10:00 a.m. and 4:00 p.m., and mutual fund investors shoulder that risk on every trade.

The fact that mutual funds are priced only once a day at 4:00 p.m. is one of the primary reasons markets tend to move so much during the last 30-45 minutes of the trading day. Mutual fund managers who trade the underlying securities owned by the fund send their trade orders in an order type called Market on Close (MOC) orders. A MOC order is a trade that is not executed at the time the trade is made but rather at the closing price on the day of the trade (typically 4:00 p.m.). If the mutual funds are selling their portfolio securities for any number of reasons, including pressure from large redemptions by their shareholders, then the traders need to accommodate those trades and sell enough shares before the close. Thus, there can be big market moves in the last minutes of the trading day. Again, the same is true for when they are buyers, but no one seems to complain about those situations.

Keep in mind that there is close to $18 trillion of mutual fund AUM as compared to nearly $3.5 trillion of ETF AUM. Hard to accept that ETFs impact the markets, especially in comparison to mutual funds given the difference in assets invested and the contrast of pricing mechanisms.

Another advantage of having ETFs trade on exchanges is that the trading in ETFs is mostly in shares of the ETFs and not in the shares of the underlying securities. As a result, ETF trading in most circumstances does not impact the price of a market index like the S&P 500 because market participants are only trading shares of the ETF back and forth, not the shares of the underlying securities. In other words, millions of shares in SPY (the ETF tracking the S&P 500 Index) can trade without buying or selling any shares of any company in the S&P 500 Index. While this might not always be the case for ETFs that track less liquid securities, trading in less liquid securities has always been a market structure issue that is difficult for the regulators to solve. It is not an ETF issue but a markets issue.

HFT, like ETFs, is often targeted for disrupting the markets. However, it isn’t the problem either and like ETFs, it is highly beneficial to markets. Back when there was a floor-based exchange and brokers were the market’s intermediary, they could take anywhere from six cents to 50 cents out of every trade. High frequency traders, one of today’s key intermediaries, trade for fractions of one penny. HFT’s impact on the cost of a trade is negligible versus the liquidity HFT provides. Yes, there are bad actors, but the regulators have caught up to most of them by outlawing many of the order types and practices that were harmful. In fact, the regulators are catching up to technology changes quicker than they ever have.

If not ETFs and high-frequency trading, it must be algorithms that are to blame when markets behave erratically.  Not so fast.  A lengthy argument can be made that algorithms are just doing what humans have asked them to do. They do not cause the market to move, they just speed up the process. Back in the days before algorithms, the information that traders and investors needed to make decisions was very fractured. The institutional and professional investors had access long before the retail investors ever did. Brokerage houses that had the information called their institutional clients first, mostly with information they received from their hedge fund clients. When markets sold-off or ran higher, retail was last in the pecking order of the information flow. For example, if there was a 20% sell-off in the market, retail investors would not be able to react to it until after the market was down and in some cases, more than 15% down. It might have been an orderly sell-off that took a week or two to filter out, but the retail investor was at a major disadvantage.

Fortunately, regulatory and technology changes came along to level that playing field so information now flows quickly and to all market participants at the same time.

Today, thanks to technology, that “sell signal” is disseminated to everyone at the same time. Thus, everyone is a seller and markets move faster. Some people call it the “herd mentality.” Everyone is now reacting to the markets in the same way because we all have the same information at the same time if we look for it.

The markets aren’t perfect, market structure isn’t perfect. But, we reap the benefits of the most liquid, most regulated and fairest markets in the world despite what the conspiracy theorists say.

A news item, a presidential statement delivered through a Tweet or a geopolitical incident can project uncertainty in the markets and trigger market signals, which will move the markets. ETFs are not to blame and neither are algos or HFT; it’s just the natural order of the markets in today’s digital age. But if you still feel the need to play the blame game, then blame the speed of information.