The market for Exchange Traded Funds (ETF) has grown rapidly in the past decade, tilting the balance of power in favor of investors. ETFs are now utilized by a growing number of fund managers for tactical asset allocation, completion strategies, and as a liquid cash substitute, their attractiveness underpinned by their relatively lower costs, speed of execution, and transparency.

The expansion of the ETF market has reduced costs for asset managers and squeezed full-service brokerage commissions. The market is now entering a new phase of growth as ETF trading expands globally. Meanwhile, there is controversy over some of the newer ETF products that employ leverage and active management to enhance potential returns, but may have higher tracking errors and debatable outperformance compared with the older passive ETF structures. Studies have shown that the returns of active and passive structures aren’t significantly different, and in some cases, actively managed ETFs have posted a worse performance than their passive equivalents.

In this paper, we examine the growth of the market, the pros and cons of the newer ETF products, and the competitive dynamics of the ETF industry. We argue that synthetic products do have some cost advantages over physical replication strategies – and in many cases the risks associated with these products have been overstated. Nevertheless, a lack of transparency and the wide range of synthetic ETF products available places retail investors at potential risk as they lack the expertise of institutional investors in assessing the risks associated with individual products.

We note that as the ETF market matures, trading costs continue to fall and the ETF trading market share is likely to rise further, increasing cost pressures on full commission brokerage firms. ETF issuers will launch more niche market products, some of which will struggle to gain critical mass in terms of assets under management. The fading of momentum-based trading and their replacement by range-trading markets will underscore the demand for more thematic structures going forward. Accordingly, we expect ETF development and construction to consume more resources and investment from both the incumbents and new entrants. We suggest ways in which outsourcing can help contain issuers’ costs as well as permit more rigorous pre-launch testing of new products and increase transparency through more detailed disclosure as this nascent market evolves and expands.

Author:

Andrew Houston, CFA, Co-founder, Amba Research