(By Mani) Exchange traded funds, or ETFs, should continue to expand and gain market share as they are expected to become an increasingly popular tool in portfolio construction. This, in turn, could lead to asset outflows from actively managed funds and further inflows into passive strategies.
An exchange-traded fund trades on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, much like a mutual fund.
While passive investing has received a lot of attention recently, Morningstar estimates that ETF assets under management comprise just about 12 percent of total ETF and mutual fund assets, implying that there is certainly room for growth.
"ETFs are being increasingly used by registered investment advisors and other types of financial advisors as a portfolio management tool to increase or reduce exposure to certain asset classes. In a sense, the role of the advisor has evolved," RBC Capital Markets analyst Eric Berg wrote in a note to clients.
Meanwhile, investors are focusing increasingly on investment management fees and are not willing to pay alpha-level fees for beta-level performance. This does not come as a surprise as since 2001 there were only 2 years in which a majority of actively managed funds beat their respective benchmark.
In nine out of the 11 years, the majority of active managers under-performed their benchmark, and the lack of performance made investors turn to ETFs.
It is going to be increasingly difficult for active managers to attract assets into core strategies, especially when portfolio managers "hug" their respective benchmarks and do not produce net returns in excess of their respective benchmark.
"There should be no doubt that portfolio managers who can generate alpha will continue to prosper. However, investors could become increasingly discriminatory," the analyst said.
Meanwhile, advisors are transitioning to an asset strategist role, de-emphasizing picking funds based on investment style or style drift, and focusing more on asset-allocation strategies since traditional approaches such as the buy and hold strategy produced demoralizing results during the financial crisis.
"As more advisors become knowledgeable about ETF products available to them, we would expect the usage of ETFs to increase. After all, the multiplicity of available ETF strategies allows advisors to change the risk characteristics of their clients' portfolio in an efficient manner," Berg said.
In addition, extending the maturity of a fixed-income portfolio, or the credit risk attribute of the bond portfolio, can now be accomplished quickly and efficiently given liquid ETF markets.
Moreover, ETFs allow advisors to take a short position in a stock to protect a portfolio, if the stock cannot be borrowed. ETFs can be used to write covered calls to improve portfolio yields. Alternative ETFs allow building positions in gold and other commodities.
"ETFs provide flexibility, liquidity and transparency at attractive costs. We believe these attributes will make ETFs increasingly popular in the future, reshaping the asset management industry over the next decade," Berg added.