One of the most interesting and original analysts covering Wall Street is Nicholas Colas, ConvergEx Group chief market strategist.

So we always perk up when he turns his attention to the $1.2 trillion ETF business.

For example, earlier this month he penned a counterintuitive piece about how investors have pumped billions of dollars into ETFs with terrible three-year track records. [Investors By Worst-Performing ETFs]

On Monday he was out with a note featuring high-level observations on the ETF industry, including the role of innovation, how the business may break into 401(k) retirement plans, and the popularity of dividend ETFs.

Below are some excerpts from Monday’s note:

Summary:  We recently completed our second quarterly survey of a variety of Exchange Traded Fund (ETF) sponsors, representing well over half of all assets in U.S. listed funds, as well as other opinion leaders in the space.  The topic this time around was “Innovation” and its current and future role in further asset growth.  While new investment products are always the most visible piece of this topic, our survey respondents had a wide range of additional perspectives.  Upcoming changes in distribution channels, primarily in 401(k) plans, was at the top of many lists.  One intriguing new topic of discussion was the role of mass-market advertising in long-term brand awareness.  As far as important near-term issues, several sponsors mentioned that the uncertainty over personal tax rates in the U.S. could unleash a wave of tax-related harvesting of both gains and losses in the fourth quarter, making the traditionally strong Q4 money flows into ETFs even more pronounced.

I recently had a wide-ranging set of discussions on the topic of “Innovation” with 10 opinion leaders and day-to-day business people from the world of Exchange Traded Funds.  Most work for ETF sponsors in a variety of roles, from marketing to product development to C-level management.  In aggregate, they represent well over half of all assets in the U.S. listed ETF universe and all major asset classes.  As a condition of their participation in this survey, none of their comments are directly attributed to the person who made them.

Here are the most interesting points these thought leaders made in the course of the many hours of conversation:

#1 – Innovation in the ETF industry goes far beyond new products.  Since the launch of the SPDR S&P 500 ETF Trust – commonly known as the “Spyders,” now with $107 billion in assets – in 1993, ETFs have grown into a $1.2 trillion industry.  Their continued growth over the last five years stands in stark contrast the mutual fund industry, especially when it comes to domestic equity-related products.  Over the past half-decade, U.S. listed mutual funds dedicated to this asset have lost almost $500 billion in assets, while ETFs that focus on the same investment class have added $219 billion in assets under management, for example.

One senior executive we spoke to put this growth in a broad perspective, pointing out that a whole range of innovations drove this expansion.  There is essentially a virtuous circle of new investors (seeking lower management fees and greater transparency) who invest in ETFs that that interacts with major brokerage firms, which dedicate staff and capital to facilitate ETF liquidity.  The result is economies of scale, a central feature of most successful Wall Street business models.  As this feedback loop grows stronger and assets grow, ETF sponsors can add incremental and more complex products with the knowledge that the brokerage industry has the infrastructure to support them and investors will take the time to examine their utility.  “Liquidity begets liquidity” is a core mantra of the industry, and for good reason.

#2 – As for important trends over the next 12-24 months, most of our industry sources highlighted “Distribution” as a key theme.  The specific area of focus was “Defined Contribution” retirement accounts, such as 401(K) plans.  There are approximately $5 trillion in assets here according to our respondents, citing published estimates.  Retirement assets in self-directed programs (as 401(K) and others are known) are the last great bastions of the mutual fund world, since most firms that provide bookkeeping for these plans built their systems around these investment products.

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