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.