Target-date bond ETFs, another non-traditional product, could also gain popularity as interest rates rise. Because these ETFs target a specific maturity date, investors can use them to manage duration through the construction of bond ladders, much as they would with individual securities. Guggenheim and iShares have a full suite of target-date bond ETFs.
Cost pressure for smart beta. Faced with increasing competition, some ETF providers are promoting the potential for better returns through rules-based indexing strategies other than weighting by market capitalization, the traditional ranking gauge. According to Morningstar, there were 844 of these “smart beta” or “strategic beta” products as of late September, up from 673 in 2014, and the assets they manage grew from $396 billion to $497 billion over the period.
While there is substantial debate about whether smart beta works better in practice than traditional indexing, the added expense associated with non-traditional approaches is clear. Smart beta ETFs that track large-cap U.S. stocks typically have expense ratios of around 50 basis points—significantly lower than actively managed mutual funds but much higher than comparable market-cap-weighted products.
But the expense gap between smart beta and traditional market-cap-weighted products could begin to narrow in 2016 as established players enter the market and more competition among smart beta products puts pressure on fees. In mid-September, Goldman Sachs changed the playing field when it launched its ActiveBeta U.S. Large Cap Equity ETF (GSLC). With an expense ratio (after fee waiver) of 9 basis points, it trounces the smart beta competition when it comes to cost. Goldman has several other ETF products in the filing process with the SEC.
“If the Goldman Sachs smart beta ETF launches prove successful, it would add price pressure for smart beta products,” says Edward Lopez, marketing director at Van Eck Global, which sponsors the Market Vectors ETFs. “The bigger question is how well these ETFs will be able to differentiate themselves from each other and from traditional market-cap-weighted products that already have low costs built in.”
Slow progress in the 401(k) market. Although exchange-traded funds have become more popular, growth has been slow in the 401(k) market for a number of reasons. Many larger plan sponsors already have access to low-cost institutional shares and index mutual funds, narrowing or even eliminating the cost advantage of ETF-only accounts. And the tax efficiency of ETFs is irrelevant in tax-deferred accounts.
There are also operational issues. “Most companies have systems and record-keeping platforms that are not set up for ETFs, and they usually have index mutual funds available anyway, says Polefrone. “So ETFs are not cracking the 401(k) market in a big way. We might see some progress in 2016, but there are still a lot of operational issues companies need to address.” Nonetheless, Polefrone sees financial advisors making inroads into the small- to micro-plan markets populated by companies with fewer than 100 employees.
This market is vastly underserved—only about 14% of small employers sponsor some type of plan for their employees to save for retirement, according to the General Accounting Office. Many of these employers cite fees associated with record-keeping and products such as annuities as deterrents to starting a savings plan. Those concerns are justified, since small businesses with under $1 million in plan assets pay retirement plan costs as much as five times higher than plans with over $1 billion.
Recently, ETFs began emerging as a centerpiece for low-cost 401(k) options that cater to the small business crowd. In September, Betterment became the first of the so-called robo-advisors to announce an ETF-only 401(k). Slated for launch in early 2016, Betterment for Business will have fees of 60 basis points for the advisory service, plus an additional 10 basis points for internal ETF charges, for accounts of less than $10 million.
More respect for millennials. Baby boomers were the generation that ushered in a new era for mutual funds, and their children are taking up the investing torch with ETFs. According to Schwab’s “2015 ETF Investor Study,” 66% of millennials aged 25 to 35 have between 25% and 100% of their investable assets in ETFs. Those numbers fall to 30% for Gen Xers, 16% for boomers and 17% for matures. In five years, millennials expect to have a mean average of 41.7% of their investments in ETFs, nearly twice as much as their baby boomer parents.