Updated Tuesday, July 29, 2014 as of 8:57 PM ET
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The Future of ETFs: When More of the Same is a Good Thing
Friday, August 23, 2013
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Over the past 20 years, exchange traded funds have experienced astounding growth. There are now about 1,400 ETFs in the U.S. and 4,800 globally, according to statistics from BlackRock. The bulk of ETF assets (about $1.4 trillion) are based in the U.S., with total global assets hovering around $2 trillion.

So, as we hit the 20-year mark in the ETF business, one might ask: What will that future bring? I believe history is our best guide in that the next 20 years will look similar to the last 20. And that’s a good thing.

To be sure, growth has tapered a bit from its torrid 30% annual rate from 2000 to 2010, but it is still in the double digits. At the same time, according to Investment Company Institute data, mutual fund assets are just regaining ground lost after their asset peak in 2007 of $12 trillion. Since then, mutual fund assets slowly drifted back down to below $10 trillion—ending 2012 at nearly the same level as 2008.

MORE AVAILABLE STRATEGIES

Against a backdrop of global economic uncertainty, advisors have found that ETF strategies deliver a level of exposure and performance that isn’t available in any other asset class. Innovation is at the core of ETF industry growth and ETFs serve as a compliment to the existing tools currently available to advisors. As the industry continues to mature and evolve, product development will open up new opportunities for advisors to implement unique investment strategies.

Consider the current interest rate environment. Fed chairman Bernanke has given no indication that interest rates will rise before we see solid increases in employment. So where are investors to go in search of yield? There is a positive correlation between equity prices and the 10-year Treasury yield when it is below 4%. So it should not be surprising that dividend-focused ETFs have been seeing growing demand, as they give investors a highly liquid, transparent way to diversify their income sources.

Likewise, investors have been favoring ultra-short, short-term, and floating-rate, fixed-income ETFs, in order to diversify and increase yield potential. In particular, ultra-short and floating rate strategies enable investors to manage interest rate risk as these strategies can roll up the curve with any rate changes. In the same way, target maturity ETFs enable investors to build inexpensive, highly liquid laddered portfolios to manage interest rate risk.

The key point here is that product growth and innovation in ETFs has a positive tangible impact on advisors’ ability to implement flexible, cost-effective investment strategies. And we should expect that innovation to continue, particularly in the fixed income arena.

INCREASED USAGE

Another positive trend in ETFs is the substantial growth in the number of RIAs constructing portfolios consisting exclusively of ETFs. The focus for these firms has shifted from picking individual stocks and bonds to creating alpha through the use of a portfolio of ETFs. Assets in this space surpassed $50 billion in 2012 and have a very steep growth trajectory heading into 2013, according to Morningstar. This approach has been made possible by new ETFs that aim for a “better beta” (e.g., equal-weight index strategies, minimum volatility strategies), which can provide a solid, diversified core for the portfolio. Newer beta strategies can be integrated with other “core” holdings to moderate some of the concentration risk and other inefficiencies of cap-weighted indices. In addition, niche strategies (e.g., pure-style, cyclical sector, currency and regional strategies, etc.) can help advisors diversify and adjust portfolio exposures to address changing risks and economic fundamentals. Ultimately, I believe that ETFs can provide a wide range of both core and satellite options from which investors can build comprehensive, well-diversified, low-cost portfolios.

Another area of potential growth for ETFs is the retail market. A recent Charles Schwab analysis revealed that only 17% of Schwab retail investors currently use ETFs. Most hesitate to use them because they don’t adequately understand them. The need for education must be addressed, even with advisors, if ETFs are to continue their strong upward momentum. Providers need to expand these efforts, especially as they expand the range of complexity of ETF options. While ETFs generally have lower expense ratios than mutual funds, other costs such as brokerage commissions and bid/ask spreads need to be accounted for in the total cost of ownership.

When one steps back to take in the full impact of ETFs, the picture is impressive and, I believe, nearly entirely positive. ETFs are valued for their wide range of investor benefits: transparency, flexibility, tradability, low-cost, and tax efficiency. Advisors have enthusiastically embraced ETFs for their ability to diversify current holdings and vehicles. Strong asset growth has come from innovation and an ability to address investor challenges, while providing new kinds of opportunities. That is a history to be proud of—and a track record we could stand to have more of in the 20 years of the ETF business.

William Belden is the managing director of product management for Guggenheim Investments.

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