Several ETF executives we spoke to expect the landscape to change in the next 6-9 months, as several major 401(K) platforms aggressively expand their offerings to include ETF offerings. The names I heard included industry leaders Schwab and Fidelity, and this news has also made its way into the trade press in the last few months, albeit with few details or confirmations. Nonetheless, our industry sources didn’t expect a deluge of new ETF assets as the 401(k) market opens up. The ability to offer ETFs is most attractive to smaller plans – say under $50 million in assets – since larger ones already have access to a wide array of relatively low cost investment choices.
To break into this arena, ETF sponsors will have to develop a range of asset allocation funds akin to the “Target dating” approach used by mutual fund companies. These are essentially equity-plus-fixed income “Balanced” products that alter the blend of the two asset classes based on the age of the investor/employee. Younger folks get more equity, with this asset class’ presumably higher rate of return over the long term; older ones get a higher percentage of bonds.
#3 – Another innovation we heard mentioned several times is the notion of active management. The vast majority of ETF assets are passively managed, hewing to a particular index or commodity price. We heard PIMCO’s name mentioned more than once as breaking some new ground on this front with their actively managed fixed income ETF product. Active management of equity products is a logical follow-on innovation, although progress here is moving along at only a slow pace.
#4 – Marketing/Advertising. One of the hallmarks of the mutual fund industry in its heyday was the “Rock star” equity manager – the Lynches, Neffs and Templetons who became synonymous with the value of active management. Yes, the fixed income industry still has Bill Gross, but the volatility of the last five years have left very few equity managers in a position to act as a credible spokesperson for the merits of “Old school” stock picking.
The most provocative conversation we had in the course of our survey related to what ETF sponsors might do to build their brands among retail investors and institutions. They do not have the ability to use an investment figurehead, in the way mutual funds built their brands in the 1980s and 1990s, of course. But as they face the prospect of marketing to millions of 401(K) participants for the first time, as well as competing in a fragmented ETF marketplace, the topic of brand building is an obvious issue. Should they advertise in mass-market periodicals? Engage celebrity spokespeople? All these venues – and others – seem to be on the whiteboards of many ETF sponsors, almost all of which are very profitable and can easily spend more advertising their products.
#5 – Predict – and follow – risk appetites. When I asked, “What type of investment do you think will gather the most assets over the next 6-12 months?” the answer most often came back: “min vol.” That’s industry shorthand for “Minimum volatility,” of course, and can range from dividend-oriented ETFs, to quality screens that pick “safe” stocks, to algorithms that select equities that have exhibited historically more muted price gyrations. Many of the executives we spoke to specifically mentioned the PowerShares S&P Low Volatility product, which has garnered over $2 billion in assets in a little over a year, as proof of this trend.
Several respondents also called out fixed income as another proof of the rising “Min vol” trend, with the industry adding innovative products to address investor appetites for everything bond related. Indeed, there have been several high-profile launches of emerging market fixed income funds dedicated to corporate bonds which prove out this point.
This trend isn’t just for volatility-shocked retail investors – institutional players such as hedge funds offer a large market for “Vol management” tools. One specialist in such products told me that there are essentially whole suites of “Version 2.0” products in the offing, all with active interest from the hedge fund community. Many will be only appropriate for such institutions, to be sure. But recall the point I made earlier about the virtuous circle between sponsors, investors, and the brokerage community. That feature, which started with plain vanilla products such as U.S. equity market index trackers, is easily leverage-able into highly specialized offerings.
#6 – Innovation plus timing equals success. Every ETF sponsor we spoke with is keenly aware of the seasonality of fund flows into this product. The industry always sees a disproportionate amount of their new capital in the fourth quarter of any year. The reason for this is straightforward: tax loss selling. As investors look to harvest losses in single stocks, mutual funds, and other ETFs, they either reinvest the proceeds in a similarly focused product or swap into another asset type. Properly executed, this exchange minimizes exposure to “Wash sale” rules while giving the asset owner continued exposure to a similar investment type.
Given the uncertainties over the future of the U.S. tax code, courtesy of the Fiscal Cliff and the upcoming U.S. Presidential election, many of our survey respondents felt the fourth quarter of 2012 could be an especially fruitful period for ETF asset gathering. Two examples here:
- Long term capital gain taxes may well rise to 23.8% in 2013 from their current 15.0%, when you include the 3.8% incremental increase from the Affordable Care Act on high income earners on top of the 5 point increase slated for these gains. Even with the stagnant equity market of the last 10 years, there are many wealthy stock investors sitting on millions – and probably billions – of dollars in long-term capital gains. That’s all dry tinder for the ETF industry, where almost half of the funds on offer weren’t even around just three ago.
- Dividends will be taxed more like ordinary income, rather than at 15%. The peak rate, again for high earners, will go to 43.4%. How this changes investor appetites for dividends overall is still a wild card, to be sure. But it is a large alteration to the existing tax code nonetheless.
In summary, “Innovation” in the context of the Exchange Traded Fund industry is a multifaceted phenomenon. There are changes underway at every level of the industry’s business model, from distribution to marketing to product development. To my eye, that bodes well for its continued growth. New products get much of the attention, of course, but the foundation for further gains in assets under management is broader that this single feature of the landscape. Innovation in any field seems to enable growth when it spreads the deepest and widest roots, after all.