ETFs continue to disrupt asset management industry

Exchange Traded Funds conquer more and more market share at the expense of traditional funds. If that triumph continues, passively managed equity assets could exceed actively managed equity assets by 2023.

Juergen Buettner

Exchange Traded Funds (ETFs), that track indexes like the Dow Jones Industrial Average, S&P 500, Nasdaq-100 Index etc., are nowadays very popular among investors – a trend that is reflected in the capital flows. While traditional equity funds, which rely on an active selection of individual stocks, have been losing market share for years, passively managed investment products are increasingly in high demand. If that development continues, according to Bank of America Merrill Lynch (BofAML) in the not too distant future this could lead to the following tectonic shift: Passively managed equity assets could exceed actively managed equity assets by 2023, at least based on the projection of trailing five-year growth rates.

Why that happens has a lot to do with the performance: Many actively managed funds simply often fail to beat their benchmark in the long term. The extent of the failure can be seen in the attached table, which is taken from a report published by the French investment bank Natixis. According to that 98% of all global equity funds performed worse than their benchmark over a 10-year period. This result raises inevitably the following question: Why should investors put money in these established products, when alternative offers are available, which at least promise a market-conform performance and that at much lower cost (in some cases the expense ratios are only 0.3 percent per year compared to over 1% yearly cost for actively managed mutual funds).

Critics warn of potential risks

How big the ETF-industry has become, can easily be demonstrated with the help of a few numbers. According to Factset data, the U.S. ETF had $2.4 trillion in assets as of the end of October. BofAML estimates that “passive” funds had inflows of $2.1 trillion since 2002 versus $1.8tn outflows from “active” funds. S&P Equity and Fund Research has rankings on 1,173 equity and fixed income ETFs, 356 that launched less than three years ago. At the end of 2015 based on data provided by Factset and among the investment advisors 81 percent recommend ETFs as an investment vehicle to client. This percentage was only 40 percent in 2006 and compares with a percentage of 79 percent for funds (85 percent in 2006). Altogether close to 30% of U.S. domiciled funds are now passive, as J.P. Morgan reports. That is not bad for a sector which was mostly unnoticed by the general public only 10 years ago.

However, as nearly always when an asset class is booming, there are certain risks connected with it. Looking at ETFs, critics claim that there is no longer a distinction between good and bad managed companies or between expensive and cheap stocks. For example, Inigo Fraser-Jenkins, chief strategist at the U.S. investment house Bernstein, because of that considers ETFs to be “worse than Marxism.” On top of that the experts at J.P. Morgan fear, that asset concentration could potentially increase systemic risk and therefor make markets more susceptible to the flows of a few large passive products. Others criticize a potential liquidity risk in many ETF products. In a stressful situation, one day in the future all these factors could have dire consequences, they say.

Decisive is the performance

These warnings should not be ignored, but at the same time it must be acknowledged, that ETFs are for sure not the only asset that carries liquidity risks in a difficult market situation. Beside this, the nowadays available wide variety of different ETF-products already allows investors to conduct different investment strategies, including a value approach. Therefore, the shift in favor of the ETFs should continue until the passive-managed competitors become more successful than in the past in their attempt to consistently beat the market.

To achieve the latter, some representatives of the traditional fund industry secretly may wish to soon witness a strong price correction or even a bear market. The underlying hope for such an attitude could be that at least during a difficult market period it could be easier to play out the strength of the pursued investment approach and to outperform the market. But that is probably not more than a straw a segment in decline is clinging on. Currently the experience based on the past is, that when active success occurs, it tends not to persist. According to Craig Lazzara an inhouse persistence scoreboard demonstrates that an investor has a better change of flipping a coin and getting four heads in a row than he does of identifying a fund manager who will be above average four years in a row.

Observations like this make the Global Head of Index Investment Strategy at S&P Dow Jones Indices think that the ranks of the “passivists” are likely to continue growing. A view, that is shared by J.P. Morgan’s Global Asset Allocation-team lead by Nikolaos Panigirtzoglou, since they predict the following in a note: “There is likely more room for passive investing to grow over the coming years at the expense of active managers until more low skilled active managers are removed from the marketplace and market inefficiencies start emerging for the skilled ones.”