The ETF industry has experienced strong growth over the last several years, and it’s likely to continue. Driving this growth has been a proliferation of ETFs, new entrants, and broader acceptance by a larger number of advisors. While the industry continues to expand its products and usage, it may also need to contend with a crowded marketplace, and ensure that investors understand the differences among ETFs and match their goals with the right product. With so many ETFs, advisors are having a difficult time distinguishing between them, and the underlying construction of an index may be very different from strategy to strategy. We believe education is a prerequisite for the continued success of the industry.
Today, 1,400 ETFs hold more than $1.3 trillion in AUM, both metrics increasing every year. According to a recent study from the ETF Morningstar Conference, 78 percent of advisors indicated they expected to increase their use of ETFs next year, reflecting a growing number of advisors who embrace ETFs as building blocks for portfolios.
And it’s no wonder: ETFs provide cost-effective and tax-efficient exposure, in a liquid and transparent structure. Advisors can easily access virtually any asset class or market segment. Moreover, with an ETF, advisors may be more likely to achieve a return that is closer to the benchmark than many actively managed mutual funds.
Along with the growth of the industry, we’ve seen increasing sophistication, both in product development and advisor implementation. The first phase of ETF growth fueled cheaper ways of owning broad swaths of the markets. We then began to see more creative solutions, which offered alternative weighting methodologies, fixed income and narrower slices of the markets.
The next generation of ETF growth will likely come from the continued creation of unique and differentiated strategies––as well as advisors who are committed to enhancing their skills, and buying into the idea that industry growth depends on better education and analysis across strategies.
One of the fastest-growing segments of the market has been the ETF Model Builders or “ETF Strategists.” They are typically RIAs who offer their capabilities to clients and other RIAs, have clearly defined investment disciplines and often run multiple models. In 2011, Morningstar began to track the Model Builders and now reports on 490 strategies from 120 firms with collective assets under advisement of $50 billion (June 2012). Morningstar estimates growth of 30% year to date, and 48% since September 2011.
This resembles the “Rep-as-PM” (rep as portfolio manager) at wirehouses, which has experienced similar growth. Those platforms allow an advisor to mirror the firm’s recommended asset allocation models, or to incorporate their own views, in a more scalable business model. ETFs represent an efficient
means of gaining broad-based exposure to the market segments. Advisors can also be more nimble incorporating changes due to the tradability of ETFs.
Regardless of where advisors sit, or the manner in which they incorporate ETFs into client portfolios, they must first select the investment. For example, an advisor may select among multiple weighting methodologies to gain market exposure: a cap-weighted, equal-weighted or fundamentally weighted version.
Sources: SSGA, Russell Investments, WisdomTree, RevenueShares and Factset (Weightings are as of 10/10/12 and are subject to change).
But advisors need to know the impact of the choices they make. As the data above illustrates, the underlying exposures of the different weighting approaches vary significantly, and the risk-return characteristics could also become distorted over time. In particular, the sector weightings of technology, financials and consumer staples differ significantly across cap-weighted, equal-weighted and fundamentally weighted strategies. The difference in weighting methodologies would lead to a very different client experience. Advisors need to understand the differences in exposures, and make the appropriate decision for their clients.
Investors appear eager to know more about their ETFs. Schwab recently surveyed investors, and even though they expect to increase their usage of ETFs, 45% consider themselves “ETF novices.” Schwab is the largest custodian––with $146 billion in ETF AUM as of the third quarter––yet investors report an inadequate knowledge of ETFs. With the growing complexity of ETFs, they are likely to eventually become frustrated with their investment unless education helps deepen their knowledge and manage their expectations.