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ETF Industry Trends to Watch in 2020

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As the ETF industry continues to mature, 2020 is set up to be a year of growth and change. The SEC’s new ETF rule, approval of several non-transparent ETF structures and changes in how the brokerage industry charges for transactions all have potential to impact the world of ETFs this year.

The new ETF rule makes registration of new ETFs less complicated, faster and less expensive. Prior to late 2019, each new ETF issuer had to go through an exemptive application process with the SEC, which could take years in some cases to get approved, with legal costs getting well into six figures. The new ETF rule removes the need for an exemptive application in most circumstances. This will significantly reduce the time to market and the upfront cost to establish a new ETF. ETF registration will now look much closer to traditional open-end mutual funds in upfront cost and time to market. Smaller and niche investment advisors who have remained on the sidelines may be encouraged to bring their investment program to market.

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The approval of several non-transparent ETF structures may have a similar impact by bringing new investment managers into the ETF world. Since ETFs are traded on stock exchanges, there is a need for the market makers in those ETFs to understand what is in the portfolio and to know what the current value of the underlying portfolio securities is at any given point in the trading day. Many investment portfolio managers are reluctant to disclose what they are buying and selling, as the decisions behind those transactions are the intellectual property of the portfolio manager, and how their value is compensated. This conflict in structure versus desire to keep portfolio decision-making confidential has kept many investment managers from launching an ETF.

Over the last several years, multiple firms have developed proposed ETF structures that will keep some or all portfolio data shielded from public view, yet provide market makers enough information to make an efficient ETF market on the exchanges. In 2019, these firms successfully navigated the SEC review process. These structures range in their transparency, giving portfolio managers several options in how they would be comfortable operating and offering an ETF while preserving their intellectual property. There could be a sharp increase in the number of new ETFs offered by portfolio managers that have heretofore remained on the sidelines, or only in the open-end mutual fund or hedge fund markets.

Many ETF prognosticators have been suggesting for several years that more actively managed ETF strategies will come to market, yet each year, no sizeable increase in activity materializes. The time and expense of the exemptive application process has certainly been a deterrent for many portfolio managers. Sharing intellectual property with the public is another, likely even stronger, deterrent for many investment professionals. With both deterrents improved upon, perhaps 2020 will see active ETF registrations increase with some significance.

Moves by several major brokerage firms reducing transaction costs to zero will likely accelerate the attractiveness of ETFs relative to open-end mutual funds. Twenty years ago, when reporting and performance measurement software were less developed and accessible than today, these same major brokerage firms, led by Schwab and Fidelity, built large revenue streams providing a “platform” for the burgeoning wealth management industry. The brokerage account held investment securities and mutual funds without charging the retail investor. Most of the revenue came from the platforms charging the mutual funds ongoing asset-based fees with large minimums per fund. These platform fees continue to be one of the major reasons open-end mutual fund expense ratios remain high.

This disparity in expense ratio between open-end mutual funds and ETFs will continue to drive new investment fund offerings toward ETFs and will over time encourage a large migration of assets from open-end mutual funds to ETFs. Wealth managers will have to initiate these moves to compete in an increasing environment of fee compression.

For now, one of the major sources of open-end mutual fund assets looks poised to remain. The retirement plan industry, especially the 401(k) and defined contribution/qualified plan markets, rely heavily on infrastructure that is designed around the open-end mutual fund settlement systems. Retirement plan administrators are hesitant to make major changes in systems that have worked quite well operationally for many years.

Over time, there will undoubtedly be an increasing demand for ETFs by retirement plan beneficiaries. Some of this demand will come from the attractiveness of index funds as the core of an investment program. Some will come from younger investors who are more familiar with and more interested in ETFs than traditional open-end mutual funds.

A few issues remain that keep traditional open-end funds more attractive than ETFs in certain circumstances and for certain groups of shareholders, but those issues may be shifting. Many open-end mutual funds have significant unrealized capital gains, especially with the sharp bull markets of recent years. There is a way to reorganize open-end mutual funds and merge two funds together, which does not result in capital gains being realized during the reorganization. It remains unclear whether a tax-free reorganization can be successfully navigated to convert existing open-end mutual funds into ETFs. Many legal experts believe such a reorganization can be done, and several issuers are considering undertaking the filings necessary to do so, including our organization. Assuming such a tax-free reorganization can be accomplished, it is likely a significant number of currently successful open-end mutual funds will consider reorganization.

Early-year prognostications are often no more than guesses, and there clearly is no guarantee of anything, but early 2020 does appear to be unique in offering several changes in the ETF landscape that invite action by those previously on the sidelines. Only time will tell.

About the Author

Kip Meadows is the Founder and CEO of Nottingham, a fund administration firm and white-label ETF issuer.

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