The Future of Financial Services

Non-Transparent ETFs: The End of Active Fund Management As We Know It

FoActive fund managers are seeking are seeking to license technology that will allow their funds to be traded as ETFsAre Active Managers Waving a White Flag?

With the SEC recently approving the first non-transparent ETF and active fund managers queuing up to license the technology, does this signal a waving of the proverbial white flag when it comes to the on-going battle to keep ETFs at bay?

ETFs have been disrupting the traditional asset management space for over 25 years — they were arguably among the first in what has since been a wave of products which look set to make mature peers obsolete, perhaps even altogether redundant.

The SEC’s recent approval to grant investment technology firm Precidian Investments permission to license technology that will allow actively managed mandates to trade in ETF wrappers, could prove to be a game changer for what is already an industry under immense pressure.

Whilst the term “disruption” may be being overused as it relates to financial services at present, it has some validity with the focus on the next in line – the younger generations.

Leveraging painful memories of the 2008 financial crisis and paying careful attention to vastly different consumption habits of the increasingly dominant Gen Zers, it’s fairly simple to see how the secular growth of ETFs can continue.

In turn, what “FinTechs” have latched on to is a medley of fear, financial illiteracy and some simple yet accurate propaganda e.g.

Over the last 15 years, 92% of large-cap active funds have lagged a simple S&P 500 index fund!

This fact alone has driven the trend of investors seeking passive strategies. In isolation however, this it is not a new phenomena; since 2005 investors have withdrawn $2 trillion from US domestic actively managed mutual funds and more or less plowed those funds into like for like passive/indexed products. However, during that time, an additional $1.2 trillion of new money has flowed into US domestic equity ETFs.

All of this is good news for investors, who are paying roughly half as much to own funds today vs. 2000, when weighted average fees were 0.93%. They’re paying 40% less than a decade ago and 26% less than five years ago, according to a Morningstar study. Last year alone, with aggregate fees declining by 5% vs. 2017, investors saved $5.5 billion. Hence, it’s no surprise then that 75% of new money headed for funds that came with the lowest costs.

Still, ETFs in the US only make up for 19% of invested open-ended investments, although they continue to gain share with a 10-year average growth rate of 16% vs. mutual funds just 2%.

Taken Together the market has a new generation of investors/future retirees; current retirees are drawing down on assets held in traditional higher fee products; globally there is a significant lack of understanding and literacy when it comes to financial products and services; facts state simply that performance has long been well below par for far too long; and new investors have an all too fresh recollection of the 2008 financial crisis (and what caused it)… then you add in a boat load of complexities around structures, fees and taxes, and you get a very compelling reason to look no further than ETFs as a go-to investment vehicle.

This all begs the question: who is the incremental end user and why one would seek to avoid a the mutual fund structure that has served so many for so long?

Arguing against paying active fund managers a premium for their services is unfortunately made too easy (and is also unfair to those exceptional long-time money managers who deliver year after year). However, for the sake of separating the sub-segments, a recent SPDR survey found that over the last 5 years, active fund managers collected $22.2 billion in fees on funds which actually underperformed index benchmarks (and passive funds that cost a fraction of the price to hold).

One can make a fairly sound argument for passive mutual funds vs. ETFs, but on the premise that asset managers are probably more accurately referred to as product managers, it really comes down to distribution channels and platforms given where technology is today. This topic covered here.

ETFs offer simplicity (the jargon and small print that accompanies a mutual fund will give even the biggest financial geeks a headache), intraday liquidity, low costs, more specific exposures and idiosyncratic investment opportunities e.g. YOLO, low to no minimum investments and tax benefits. Morningstar do a great job of putting them head to head here.

Again, to save on an essay, the SPDR blog offers examples of how capital gains distributions and “tax alpha” works here. But, in short, because ETFs are traded “in kind” i.e. the holder of an ETF unit is entitled to ownership of the basket of securities which comprise any given ETF, there is not always a need for buying or selling of those securities when an ETF is bought/sold. In buying/selling a mutual fund however, an investor asks of the fund manager to buy/sell the underlying in order to satisfy a unit of said mutual fund, which more often than not creates tax liability on the underlying assets. Liabilities are not necessarily accompanied by a capital gain on the overall investment.

With key concerns about fast money coming in and out of ETFs — whilst this is unquestionably true — BlackRock’s survey on ETF usage highlights some encouraging trends for the industry with “only 5% of surveyed investors using ETFs for short-term investments i.e. <1 year, whilst 34% planned to increase their use for long-term investing.”

Going Full Circle

Whilst it appears that the writing is on the wall for the traditional asset management industry; fee pressure and less demand, similar to the majority of financial services disruption stories, the largest players still have both sacel and too much to lose not drag their feet — this will certainly buy time. But, also similarly seen in other disrupted industries, consumer preference will ultimately win out. ETFs are still dwarfed by regulated open ended investment vehicles (by 10:1), but the gap is being closed. One VC investor in Robinhood and other robo-wealth platforms cited that 1 in 2 brokerage accounts opened in the US last year were with Robinhood.

What’s more, with assets last year almost entirely heading for funds with the lowest expense ratios i.e. those charging less than 20bps or 0.2%, fee pressure is likely to persist. Hedge funds are hanging on to relevance for dear life and recent economic and geopolitical turmoil has made stock picking incrementally more difficult (high correlation and low dispersion FWIW). Further, regulatory changes have seemingly left new entrants with the upper hand e.g. DoJ Fiduciary Rule, (subsequently chopped under Trump), G-SIFI , MiFID II — which ultimately brings the focus back to a morphing investor base and change in preferred investment platforms.

Where we shake out, somewhat unfortunately, is without a black and white conclusion, but with some semblance of what the future holds. Many have argued the focus is going to be on developing economies and the emerging middle class within. For example, PWC estimate the HNWI and mass affluent sub-sectors will comprise more than 63% of client assets globally by 2020.

As previously alluded to, better education and more frequent publication on topics such as fees will lend themselves to pressures whilst forcing asset/product mangers to compete even more so on price. A recent Nerdwallet blog post hit this home, their research suggested that a 1% fee could cost the average ill-fated millennial $590k in retirement savings over the course of their lives.

To suggest the asset management industry is doomed is perhaps a step too far, but to suggest that traditional mutual funds as they are known today will be a thing of the past is not out of the question. If active mangers can reduce fees and deliver on performance, all whilst offering the benefits of the ETF structure discussed throughout, there is no reason to believe that those funds would not see demand over time. History will however tell you that is a BIG if.

The world’s largest money manager perhaps confirms this thesis. BlackRock stepped away from domestic active investing some time ago, and have built a $1.5 trillion ETF business in its place, supplementing this with active strategies where required and quant everywhere else. Their most recent institutional investor survey suggests they were right to do so, with the focus being on product offering and scale over margin, and a recent KBW ETF survey citing institutional investors as the remaining key growth driver if/when they choose to allocate more capital towards ETFs. The real winners here are those who license their indexes to the issuers e.g. S&P Global and MSCI, among others.

To Conclude

Whilst the numbers still paint a picture to suggest that incumbents remain in the driving seat of this industry, innovators and new entrants are tirelessly working away to change the landscape. More importantly, they’re working to change consumer perception and behavior/habits. Often fittingly in cases of the disrupted, the famous Earnest Hemingway quote depicts the tipping point of surprise when referencing how one went bankrupt “gradually, then suddenly.”

Clearly the strategic rationale behind a non-transparent ETF is to allow traditionally managed mutual funds a wider audience, notable those flocking to robo-advisors and/or digital finance platforms. Yet it also offers some suggestion that there is concern over relevance in the changing world where technology meets finance.

Whatever happens, the evidence is in the flows to ETFs and to those mutual funds who can afford to operate charging fees low enough to get attention. The outcome of this topic really leaves us to address how platforms will play more of an important role than products (see here) , but nonetheless, it signals one fairly sizable step forward for the innovators.