ETFs: A Positive Force For Disruption by Ernst & Young

Executive Summary

Our latest global survey of the ETF industry was conducted against a far less stable backdrop than in previous years. So it was striking to find that interviewees remain extremely confident about their prospects for growth. A weighted average of global responses suggests that respondents expect their businesses to grow by around 18% every year for the next three to five years.

Perhaps this should not come as a surprise. Experience has shown that the ETF industry has a rare ability to turn investment problems into investment solutions. The sector has also weathered a number of crises over the past two decades and, throughout that time, investors have continued to support ETFs by voting with their feet.

The industry’s increasing size is not without its drawbacks. Chief among these is an ever-growing level of external attention. While most respondents welcome closer scrutiny, there are concerns about regulatory misunderstandings and the associated potential for reputational risks. And, while the ETF industry mainly continues to get a good press, some interviewees admit to frustration at the way that market volatility is sometimes labeled as “an ETF problem.”

On the upside, greater size brings greater influence. Active managers with no history of issuing ETFs are being forced to respond to developments such as smart beta, with many choosing to launch ETFs or partner with existing providers. There could be no clearer sign of the growing impact that the ETF industry is having on the wider regulated funds sector and the asset management industry as a whole. To explore these issues in greater depth, we have structured this report into several key sections:

  • Section I examines the industry’s global drivers of growth and profitability, and suggests that we may be seeing a permanent shift in the industry’s vision for expansion.
  • Section II reviews the defining themes of US, European and Asian markets. It shows that, while the industry as a whole is shaped by global trends, regional differences in regulation, demand and infrastructure continue to shape different ETF markets in different ways.
  • Section III focuses on the crucial topic of innovation, and considers the potential benefits and risks of recent and upcoming product developments. It concludes that, while innovation is increasingly central to the industry’s growth, it is also creating some potential tensions for ETF providers to address.
  • Section IV examines three hot topics: structural innovation, digital distribution and the search for efficiency. If there is one common theme to emerge from these areas, it is the need for promoters, market makers and service providers to keep the needs of investors at the top of their agenda.

Looking across the ETF industry as a whole, we see huge energy, exceptional creativity and immense promise for the future. The industry has a strong track record of adapting to different markets, and we expect that to continue as it expands into new regions, such as Latin America and the Middle East. We are also struck by ETF providers’ desire to work with investors and tailor products to their needs — an attitude that is not always a feature of every corner of the asset management sector.

At the same time, we would like to remind the industry of a few eternal truths. One is that innovation and creativity always bring controversy and, inevitably, some risks. Another is that ETFs depend on a strong ecosystem and close cooperation between providers, authorized participants, market makers and service providers.

We would also like to sound a warning to the industry: in its rush to deliver growth over the next two to three years, it needs to ensure that it does nothing to harm its potential expansion over the next 5, 10 or 20 years. As it grows in size and influence, the ETF industry needs to ensure that it continues to act as a positive force for disruption.

A New Vision For Growth?

The ETF industry’s growth over the last two decades represents one of the financial sector’s greatest recent success stories. Can this continue? Our survey allows us to gauge the industry’s own predictions for its future growth and profitability.

More than 90% of those surveyed expect the industry as a whole to enjoy positive net new business over the next 18 months, with 34% predicting net inflows of more than 20% (see Figure 1). Firms are even more confident about their own growth prospects. Almost all our respondents expect to achieve a cumulative annual growth rate of more than 10% over the next three to five years, and more than a quarter predict annual growth exceeding 25% over the same period — equivalent to a two-to threefold increase. Despite some regional variations, the overall picture is one of very strong confidence (see Figure 2).

ETFs

ETFs

These bullish predictions are nothing new, but they are all the more striking for being made against one of the most challenging market backdrops the ETF industry has faced in recent years. Volatile equity markets during the first nine months of 2015 have led to global year-to-date growth of 0.9% in ETF assets, a far cry from the industry’s 10-year cumulative average growth rate (CAGR) of 24%. Our survey shows that several mutually reinforcing factors explain the industry’s confidence in the face of unstable financial markets:

  • A favorable macro view. Investment philosophies that emphasize diversification and cost minimization as drivers of long-term performance have steadily gained ground since the financial crisis. Future decades are expected to see strong demand for affordable, diversified investment products that can be used to build tailored portfolios. The industry expects to continue to take market share from traditional active asset managers and passive mutual funds, and sees fiduciary managers as a very limited competitive threat.
  • The weight of institutional money. Institutional investors continue to drive the bulk of ETF inflows, especially outside the US, but remain comparatively underinvested in ETFs. It follows that ETF providers see huge scope for further institutional growth. Our survey confirms this view: 92% of the investor groups we surveyed expect to increase their allocations to ETFs over the coming year. Institutional investors are using ETFs for core exposures, precision exposures and hedging. ETFs are increasingly seen as a substitute for fully funded futures, as the cost of holding long positions on key indices increases with every quarterly “futures roll.” Defined benefit (DB) pension funds are becoming significant users of ETFs in many markets. Insurers are also beginning to use ETFs for long-term investment, not just short-term hedging, although most respondents see them as slower adopters.
  • A wave of innovation. Our survey shows that ETF promoters expect innovative products, such as smart beta funds, to continue to supercharge net industry inflows. Many providers see these value-added products as the key to attracting new institutional investors. Others also see innovation as a retail “investment story,” giving individuals the kind of flexibility only previously available to institutions. We focus on innovation in greater detail in Section III.
  • Long-term retail growth. Many respondents to our survey view retail investors as the industry’s most important long-term driver of net inflows. But near-term predictions are more modest, suggesting that it will take at least a
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