At first glance, it was business as usual for providers of exchange-traded funds in 2013. Roughly 150 new funds were launched this past year (, almost equaling the 168 new funds that were launched in 2012. Total assets under management, spread across more than 1,500 funds, have grown nearly 25% this year, closely matching the stock market’s rise.

Funds flowing into ETFs have cooled a bit. The industry pulled in a record $190 billion in 2012, according to Morningstar, and brought in another $152 million through the first 11 months of 2013. A $25 billion flow out of commodity funds explains most of the drop-off.

But beneath the surface, major changes are afoot. A closer look at the key trends among ETFs in 2013 sheds light on what to expect in the year ahead as well.

Race To Zero
Over the past decade, many ETFs have deployed passive investment strategies that carry expense ratios in the 0.40% to 0.70% range. That pricing was seen as the sweet spot for clients, leading them to slowly migrate their assets away from high-cost, actively managed mutual funds. Yet price wars are breaking out, and newly launched ETFs are offering rock-bottom expense ratios.

Fidelity Investments, for example, launched 10 new funds in late October, and each carries a 0.12% expense ratio. And you can still find even lower expense ratios: The Vanguard Total Stock Market ETF (VTI), for example, has a minuscule 0.05% expense ratio. But as Fidelity, Charles Schwab and others make a deeper push into ETFs, higher-priced competitors may be forced to cut fees, according to Todd Rosenbluth, director of ETF research for S&P Capital IQ. “From an investor standpoint, it’s great,” he says, adding that many more low-cost ETFs are likely to come to market in 2014.

For firms like Fidelity and Charles Schwab, the push into ETFs doesn’t necessarily represent a desire for market leadership in this fast-growing category. Instead, these firms simply aim to capture assets that were being siphoned away by other ETF providers anyway. Indeed, Fidelity’s aggressive push into ETFs has been done with a great deal of product development support from BlackRock’s iShares unit—a move which would have been unthinkable five years ago.

“We call it ‘co-optition’ and you’re seeing more of it as industry fears about partnerships diminish,” says Daniel Gamba, head of iShares Americas institutional business. “Fidelity partnered with us to quickly build a platform for self-directed investors, which is a market where we don’t have a big presence.”

The move by Fidelity comes as ETFs evolve into a potential threat to mutual fund hegemony. ETF assets under management (AUM) have surged from $531 billion at the end of 2008 to a recent $1.6 trillion, according to Cerulli Associates. And though mutual funds still rule the roost, with an estimated $10.7 trillion in AUM, relative growth rates imply that ETFs are gaining ground.

Might mutual fund giant Franklin Templeton be readying a major push into ETFs as well? The just-launched Franklin Short Duration US Government ETF (FTSD) appears to be an effort to test the waters, and industry watchers are waiting to see if the firm, which offers more than 200 mutual funds and has more than $800 billion in AUM, aims to make a bigger splash in the ETF space in 2014.

Also keep an eye on JP Morgan, which has historically provided a range of back-office services (such as global custody, fund accounting, fund administration, transfer agency and basket settlement services) to ETF providers, but now aims to have its own branded products. A recent filing for the JPMorgan Global Equity ETF is expected to enter the rapidly growing niche of actively managed ETFs, known by some as “smart-beta” funds. Indeed, this approach likely characterizes the top ETF theme for 2013.

… And The Race To The Top
“[2013] was the breakout for hedge-fund-like strategies,” says IndexIQ Chief Executive Officer Adam Patti, referring to the increasing popularity of “smart beta” funds. Both institutional and retail investors are trying to find ways to beat the market and not merely keep up with it. Patti thinks that financial advisors are an increasingly important client for the industry as well. “Most advisors were just dabbling in ETFs five years ago, but now they’re looking to build a portfolio of ETFs for clients, and the new breed of actively managed funds is surely gaining traction,” adds Patti.

There are now nearly 400 smart-beta ETFs (which are also known as “fundamental,” “enhanced indexing” or “strategic beta” ETFs), with more than $157.6 billion in AUM. Under that umbrella, you’ll find funds that focus on:

• Contango/backwardation (i.e., ETFs that focus on the rollover of short-term contracts).
• Long-short spread funds.
• Technical analysis-focused funds.
• Funds that focus on general fundamental approaches, such as low P/E or high-growth stocks.
• Risk/volatility funds.

All of these funds tend to carry higher-than-average expense ratios and a higher degree of portfolio turnover. As the ETF industry titan, it’s no surprise that BlackRock’s iShares program has pursued the “smart-beta” niche aggressively. (BlackRock has more than $650 billion in AUM, which is more than the combined AUM of State Street and Vanguard, the industry’s second- and third-largest fund sponsors.)

 “We’ve found that both institutional investors and self-directed individual investors are embracing these products,” says iShares’ Gamba. And that trend could lead to trouble for mutual fund firms. “The emerging spectrum of passive/active ETFs is going to lead more investors to question the wisdom of paying (relatively higher) mutual fund management fees,” says Ben Johnson, Morningstar’s director of passive funds research.

Gamba cites three classes of actively managed funds that have been a focus for iShares: One is minimum-volatility ETFs such as the iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV). The second class is factor ETFs, which were launched earlier in 2013 and focus on a particular investment attribute such as momentum, value, size and quality. These offerings include the iShares MSCI USA Quality Factor ETF (QUAL) and the iShares MSCI USA Size Factor ETF (SIZE). The third class is enhanced ETFs that seek to outperform index-based passively managed ETFs. Examples include the iShares Enhanced US Large-Cap ETF (IELG) and the iShares Enhanced US Small-Cap ETF (IESM).

Yet even as the industry moves to develop more “smart-beta” funds, no firm can ignore the fact that price wars are breaking out. IShares offers a line of 10 “core” ETFs that have amassed $100 billion in AUM, such as the iShares Core S&P 500 ETF (IVV). “‘Buy-and-hold investors’ really focus on fees, and the popularity of these core ETFs means we will be launching more of them in 2014,” says Gamba.

Fixed Income’s Tectonic Shift
Despite an ongoing rebound in interest rates, investors aren’t shunning fixed-income investments. They’re simply moving them into ETFs. “Fixed-income mutual funds continue to see steady outflows,” according to S&P Capital IQ’s Rosenbluth. “As most bond-focused mutual funds are passively managed anyway, investors see less reason to shoulder their higher expense loads (relative to ETFs),” he adds.

Not all fixed-income ETFs are gaining traction. Investors realize that many funds would lose value if interest rates rose as bond prices fell. “So ETF investors are focusing on funds that are less rate-sensitive,” says Rosenbluth. These include:

• ETFs that only own short-term bonds, such as the SPDR Barclays Short Term High Yield Bond ETF (SJNK). This fund’s typical bond holding matures in 3.5 years, and the fund sports a 5.1% yield to maturity.
• ETFs that focus on floating-rate issues such as the iShares Floating Rate Bond ETF (FLOT). Nearly 95% of the portfolio is invested in “A”-rated securities.
• And ETFs that focus on senior loans, such as the PowerShares Senior Loan Portfolio ETF (BKLN). The fund’s top 10 holdings all mature between 2016 and 2020, and generally carry coupons in the 4% to 6% range.

What do these three kinds of ETFs have in common? They are all less than three years old and already have more than $2 billion in AUM. Their rapid success is likely to inspire similar offerings from other fund firms in 2014. “It’s inevitable that interest rates will move higher, so these types of ETFs are likely to remain popular,” predicts Rosenbluth.

The rising popularity of fixed-income ETFs also corresponds with a diminished appeal for bonds themselves. “People are moving away from holding long-term bonds and are finding that they can manage yield and risk more effectively with ETFs,” says iShares’ Gamba. To capitalize on the trend, his firm “will be especially active in this area in 2014.”

For investors that want to own a basket of bonds that mature at a given time, iShares has launched a series of eight new funds called “iShares Bond.” The iSharesBond 2016 Corporate Term fund (IBDA), for example, pays a coupon until 2016, at which time the investment principal is returned. “They’re great for buy-and-hold bond investors that plan to hold to maturity,” says Gamba.

Tailor-Made Funds
Another burgeoning industry trend: Products that are designed and launched at the behest of a key client. Barclays, for example, runs a pair of “bespoke” exchange-traded notes (ETNs) that are almost entirely owned by one client. Those ETNs, the Barclays ETN+ FI Enhanced Global High Yield ETN (FIGY) and the Barclays ETN+ FI Enhanced Europe 50 ETN (FEEU), were both launched in May 2013, and each already has more than $1 billion in assets under management. That makes them the most popular new ETFs of 2013, in terms of AUM. (The Vanguard Total International Bond ETF [BNDX] and the SPDR Blackstone/GSO Senior Loan [SRLN] are also among the top new funds of 2013, with each already controlling more than $500 million in assets.)

Barclays’ success with bespoke funds is being noted in the industry, as are the iShares Factor ETFs, which were launched earlier in 2013 at the behest of the Arizona state pension plan. Look for more of these bespoke funds to launch in 2014, according to iShares’ Gamba.

Survival Of The Fittest
Taken together, BlackRock (with its iShares program), State Street and Vanguard control $1.3 trillion in ETF assets, according to XTF Research. That leaves the other 50 or so fund firms to tangle over the remaining $350 billion in industry assets. And the tough battle for market share has pushed smaller firms such as WisdomTree Investments, ProShares Advisors, Van Eck Associates (Market Vectors), Global X, Guggenheim Funds Distributors and First Trust Advisors to become product innovators. “They’re being pressured to find small, increasingly niche products to bring to the market,” says Morningstar’s Johnson. He cites WisdomTree and Invesco PowerShares as fund firms that have found success “using strategies that help them stand out in the crowd.”

These firms will admit that not every clever new niche ETF is greeted with a strong market response. But when they succeed, the results are impressive. Take the IQ Hedge Multi-Strategy Tracker ETF (QAI) as an example. This ETF has seen its AUM more than double this year, as investors flock to a new category of funds that own a diversified set of assets. That result has emboldened the fund’s sponsor, IndexIQ. “We’re certainly accelerating our product rollouts in 2014,” says IndexIQ’s Patti, citing the success of the QAI fund.

So how do these firms figure out what new products to launch? “We do a lot of market research, talk to advisors, and then build the product—it’s a two- or three-year cycle,” says Patti. That suggests that key 2014 ETF launches are already entering their final development phase before going to the SEC for review.

Some ETF firms may look to expand their industry partnerships as a way to stand out in the crowd. Van Eck, which has managed to bring in nearly $500 million in AUM with its Market Vectors Wide Moat ETF (MOAT), attributes some of the fund’s success to a relationship with Morningstar. “A partner like Morningstar, with its high quality team of analysts, has been great,” says Ed Lopez, marketing director at Van Eck.

While these smaller fund firms are thrilled to see a new ETF gain solid traction, many of their offerings don’t fully resonate with investors, which can lead to some tough decisions. “Any ETFs that have less than $50 million in assets after a few years are vulnerable to closure,” says S&P Capital IQ’s Rosenbluth. “Bigger firms such as iShares, Vanguard and State Street can be very patient, but the smaller firms don’t have that luxury,” he says.

Indeed, a record 81 ETFs (and 12 ETNs) were shuttered in 2012, according to the Investment Company Institute (ICI). Though the tally for 2013 is likely to be a bit smaller, many funds remain quite vulnerable. “Many thought this would be the year that the ETF industry finally saw net closures (i.e., more closures than new fund launches), but clearly that didn’t happen,” says Morningstar’s Johnson. What about 2014? Considering that roughly 200 funds have less than $5 million in AUM, according to ETF Global, analysts still anticipate an uptick in closure activity.

And it’s fair to ask: Just how many ETFs are enough? After all, with more than 1,500 funds to choose from, “me too” products keep appearing on the scene. That’s why ETF firms must continue to search for new and innovative approaches that truly represent a fresh way to gain an edge in today’s market. One thing is for sure: A year from now, ETF investors will be flocking to new and unique funds that will be hatched in the New Year.

And if history is any guide, the ETF industry is poised to control more assets, perhaps at the direct expense of mutual funds and stocks. S&P Capital IQ’s Rosenbluth predicts that 2014 may be the year when the mutual fund industry really embraced ETFs. Fidelity, Franklin Templeton and others might look to make a big industry push that raises the bar for existing ETF providers and creates even more options for investors. For an industry in flux, 2014 promises more surprises.