With a shifting landscape, how can both ETF and mutual fund managers be poised to adapt their business to take advantage of newly launched ETF products?
It’s no secret that retail investors have been flocking to ETFs over the past few years. The tax efficiencies and fee structure that they provide have made them incredibly attractive — one of the main reasons why 64% of advisors view them as critical to their clients’ portfolios, according to BNY Mellon Pershing’s 2016 report, The Evolving ETF: Using Exchanged Traded Funds in Client Portfolios.
ETFs have been a disrupting force, forcing mutual funds to adapt and innovate.
However, current trends are pushing both instruments to a point where their differences are getting less obvious.
These trends put increasing pressure on both ETF and mutual fund managers to consider their overall product strategy to stay competitive.
Faced with the reality of their market share being carved away, mutual funds have begun to mirror the benefits of an ETF in order to stay competitive, starting with ease of access.
To do that, mutual funds are exploring the use of stock exchange technology. Surprisingly, this adaptation does not involve a massive structural change. Trades simply flow back to the fund level or distributor. To a trader it looks like they’re buying a share, but the process between the transfer agent, custodian and distributor remains largely the same.
In addition to adding the option of exchange access, mutual funds are lowering fees. According to Morningstar1, in 2016 investors paid lower fund expenses than ever before. The asset-weighted average expense ratio across funds was 0.57% in 2016, down from 0.61% in 2015 and 0.65% three years ago.
These changes bring mutual funds much closer to the appeal that ETFs offer and represent a serious commitment to recapture the attention of investors.
While ETFs have taken command of the spotlight, they only represent 11% of total retail wealth management2. Distribution and awareness are still major hurdles with which ETFs struggle. New funds have a difficult time getting exposure to the majority of customers, most of whom are still only familiar with mutual funds and mutual fund platforms. To them, ETFs might as well be invisible.
To overcome these issues, most fund managers are attempting to list their products on mutual fund platforms. This, however, introduces another set of challenges as today’s mutual fund platforms and fund supermarkets have not typically engaged with the wider capital markets and lack the necessary infrastructure to enable trading of securities such as ETFs. On the back of RDR and MIFID II the platforms are starting to see the benefits that ETFs can bring to their clients and are proactively working to solve these challenges.
One of the other major challenges facing ETFs are the pillars that have propelled their success. Transparency, intraday liquidity, low fees, passivity and tax efficiency can impede the success of the business behind some mutual fund strategies.
For instance, transparency creates issues making it difficult to protect the intellectual property of active fund managers. Limiting the transparency of ETFs helps prevent the risk of front running and other activities that can impede the success of the product without reducing liquidity.
Furthermore, what’s become apparent is investors aren’t married to all of the traditional ETF pillars. Retirement funds don’t need intraday liquidity and most clients simply aren’t interested in such a thorough level of transparency.
These catalysts have sparked the development of a new generation of products that could fundamentally change the definition of an ETF.
As a result of these trends, the new wave of products hitting the market are fundamentally different from what is perceived as a traditional ETF.
Smart Beta ETFs utilize both passive and active investing and have quickly become popular. Through the end of October 2017, global Smart Beta equity ETFs and ETPs saw net inflows of $59.7 billion; 53% more than net inflows for the same period during 2016, and 6% more than net inflows for the whole of 20163.
Non-transparent active ETFs are another innovation that seek to strike a middle ground between traditional ETFs and mutual funds. They maintain the benefit of tax efficiency, intraday liquidity and net asset value based trading, but are not obligated to disclose their holdings quarterly.
These two products are just the beginning of how the line between ETFs and mutual funds will continue to blur.
The trend is clear: the wall that divides ETFs and mutual funds is crumbling. New products are entering the market that eschew some of the traditional ETF pillars, yet have still been able to attract investors. The landscape is shifting again, and both ETF and mutual fund managers must be poised to adapt their business to take advantage of this opportunity.
BNY Mellon understands the full lifecycle of an ETF. So if you are an issuer looking to build a fund, we can help you with design, issuance, distribution, and management. For investors or sponsors looking to better manage your ETF portfolio, we can facilitate efficient trade execution and asset servicing.
Contact BNY Mellon below to learn more about our complete ETF solutions.
1 - https://corporate1.morningstar.com/ResearchLibrary/article/810041/us-fund-fee-study--average-fund-fees-paid-by-investors-continued-to-decline-in-2016/
2 - https://www.investopedia.com/articles/investing/102014/will-etfs-eventually-replace-mutual-funds.asp
3 - https://www.investopedia.com/news/smart-beta-asset-growth-continues-booming/
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