Six hot-topic trends for ETFs in 2017

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The Inside ETF conference has begun, and by all accounts it is the biggest exchange traded fund gathering yet, with close to 2,500 participants spread out over four days of meetings.

I will be moderating the leadoff morning panel, Inside ETF Round Table: Where to Invest in 2017.

Here’s six hot-topic trends for ETFs in 2017:

1) Money will keep coming in

The U.S. ETF business is approaching $3 trillion in assets under management. That’s still small compared to the $16-trillion mutual fund business, but it’s growing every year.

ETFs saw $288.6 billion of inflows in 2016, according to Morningstar. Mutual funds had $90.8 billion in outflows last year.

A survey of ETF professionals by PwC (PricewaterhouseCoopers) found that North American firms in the survey predicted ETF assets under management would grow to $5.9 trillion by 2021. That’s 23 percent cumulative annual growth.

Partly, this is because most ETFs are passively managed, indexed-based structures. Indexing has won out against active investing, and investors are voting with their feet. Even within the mutual fund industry, $233.3 billion flowed out of actively managed funds in 2016, while $226 billion flowed into index funds.

But there’s a second reason ETFs have been winning out: Lower cost is king, and that’s a trend that has been going on for a decade and shows no signs of abating. They are cheaper alternatives for both active and passive management. “It’s not so much about active versus passive, it’s more about moving from high-cost funds to low-cost funds,” said Ben Johnson, head of ETFs for Morningstar.

2) Many ETF providers cut fees in 2016, and that will continue in 2017

How low can fees go? Even lower. The largest U.S-based ETFs already charge less than 10 basis points (0.1 percentage points) a year:

  • SPDR S&P 500 – 0.09 percent
  • iShares Core S&P – 0.04 percent
  • Vanguard Total Stock – 0.05 percent
  • iShares MSCI – 0.05 percent

To put this in perspective, the 0.09 percent (9 basis points) that SPDR S&P 500 charges amounts to 90 cents a year for every $1,000 invested. That’s cheap!

These are S&P 500 ETFs, but other broader ETFs are almost as cheap: both the PowerShares QQQ and the iShares Russell 2000 charge 0.2 percent.

How low can it go? For the biggest providers, fighting for a huge piece of the pie, it could certainly go lower. Here’s the big question: How close to zero could it get? How would an ETF provider make money at fees close to zero? They could charge for commissions of course, but even here the battle is getting fierce. Schwab now has commission-free trades on its OneSource trading platform, where you can trade roughly 200 ETFs commission-free. They can make money by lending securities. Or they could simply hope that they can sell you other products and services.

3) Active versus passive: It’s getting nasty.

The active management business is reeling from a tidal wave of investment money flowing out of active and into passive investment strategies, especially ETFs. S&P has noted for years that roughly 80 percent of active managers fail to outperform their bogeys.

Now the old guard is striking back. Some, like Jeff Gundlach and Pimco, have started actively managed ETFs of their own.

But others are simply getting more aggressive at denouncing the trend toward passive investing. It started back in August, 2016, when research and brokerage firm Bernstein, known for active investing, claimed that passive investing was “Worse Than Marxism.”

In September Carl Icahn attacked ETFs at CNBC’s Delivering Alpha conference, then repeated the claims in December, saying “In the market today, the danger is that you have all this money pouring in America into ETFs, and ETFs are sort of almost blind buying. You just buy these ETFs, and I always question the fact that if you’re buying these stocks and you really don’t know what you own, you’re prone to these periods of time — there could be some kind of crisis, and there could be a problem.”

4) Thematic investment keeps growing

While money kept coming in to large-cap “plain vanilla” ETFs like theSPY, there is also considerable interest in “thematic investing.” Rather than invest in sectors, some are interested in investing around very narrow niches of the market. Whether it’s Cyber Security ETF or Cloud Computing or Airlines, there is considerable interest in allowing people to invest in themes. The advantage: It gives immediate access to a small niche that is very susceptible to headlines.

5) Smart beta keeps growing

“Smart beta” combines some elements of passive with active investing. It’s still a relatively small part of the market. Take the PowerShares Dynamic Semiconductors Portfolio. Rather than track a market-cap-weighted index of large semiconductor stocks (like its cousin, the SPDR Semiconductor), the PSI invests in 30 semiconductor stocks based on a weighting of several criteria, including price and earnings momentum and the quality of management.

The PSI did outperform the XSD last year, but is about even on a five-year basis. Two problems with smart beta: a) the strategy charges more than simple index-based investing, and b) there’s still a lack of convincing academic research that would indicate smart beta in general outperforms market-cap-weighted indices or active management.

6) The ETF issuance surge is not topping out

In 1999, there were 36 ETFs with a total value of $32 billion. In 2016, there are 1,944 ETFs with $2.5 trillion under management. Plenty of people have been saying there are too many “me-too” ETFs and that ETF issuance will top out and start to decline.

Maybe, but the ETF business is unlikely to contract this year. Sure, about 120 ETFs closed last year, according to Factset. To a certain extent, this is normal. Many funds never gained traction because they were late to the game or had no clear constituency. Some were shuttered because investors weren’t that interested in the space.

Here’s why you’ll still see more ETFs: Companies in the investment business — whether they be asset managers, insurance companies, whatever — have to be in the growing ETF game, and many still are not. Those that are not are getting inquires: “They are hearing from their board of directors, ‘Why are we not in ETFs?'” said Doug Yones, head of ETFs for the New York Stock Exchange.

Yones points out another key trend: Those in the investment business may themselves be customers of ETFs. Take insurance companies. They need to invest long-term to meet future liabilities, and have an army of investment consultants to show them how to do that. They care a lot about costs and efficiency.

“What if they used fewer of those people,” Yones asked, “and instead, bring in ETFs to cover some of their obligations?”

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