During my 20 years in the financial services industry, I’ve been able to witness the rapid evolution of ETFs as these funds have increased in popularity and investors increasingly use them to express their views and position portfolios for shifting market conditions.

I had a chance to speak about this evolution when I flew to Chicago at the beginning of the summer to attend the Morningstar Investment Conference, where I spoke on a panel about ETFs.

With more than 20 years of history and more than $2 trillion in assets under management, it’s clear that ETFs have moved beyond their first phase of development. The panel I participated on with fellow industry leaders addressed ETFs 2.0: What’s next for the funds that are helping to reshape the industry?

While the panel discussion was wide-ranging, it centered on these four topics:

  1. Smart beta. Whether it’s called smart beta, advanced beta or strategic beta, our panel acknowledged that these funds, which can be described as a mix between active and passive investment strategies, are here to stay.Smart beta strategies are increasingly being used to complement active and index holdings. They combine the transparency, liquidity and flexibility of indexing with the ability to take an active view on which risk factors may outperform over time.
  2. Active use of passive building blocks. The past 30 years have witnessed changes in how financial advisors conduct business. While some are stock pickers and others work as mutual fund selectors, we have also seen more advisors are becoming asset allocators.In our experience, rather than creating portfolios to beat a benchmark, advisors are building portfolios for quantifiable outcomes tied to specific future cash flow needs, such as retirement.The panel agreed that ETFs may play a major role in how advisors build portfolios, and passive funds are being used as a replacement or a complement to active funds. Passive funds can allow advisors to embrace a flexible framework for portfolio construction that incorporates long-term strategic, core-satellite and more tactical investment solutions to meet the needs of investors across a wide spectrum of risk tolerances.

    This active use of passive building blocks has helped to spur demand for ETF strategists. These strategists work with advisors to help them implement investment strategies by researching, designing and managing ETF portfolios. This is a topic that my colleague, Brie Williams, has been covering on SPDR® Blog.

  3. The use of active ETFs: Active ETFs account for just 7.6% of all outstanding funds and less than 1% of Exchange Traded Product (ETP) assets, but they continue to grow.1 The panel spent a lot of time discussing what’s driving this growth: Is it demand from investors? Or is it managers developing actively managed funds ahead of potential investor demand?At State Street Global Advisors (SSGA), our point of view is that there are certain strategies, approaches and asset classes that may lend themselves to active management—such as fixed income.We have seen that fixed income markets have become increasingly difficult for investors to navigate and a diversified fixed income portfolio suited for the current environment isn’t easy to build. It may require more than a simple mix of US Treasuries, corporate debt and high-quality structured credit.

    We believe actively managed ETFs allow investors to “outsource the core” to managers who have experience with and a track record in navigating different fixed-income environments in order to gain broader exposure.

  4. ETFs 3.0: You can’t be on a panel about the evolution of ETFs and not be asked to make some predictions about the industry’s future.Five years from now we think that ETF adoption rates will remain high, although the pace of growth could slow as the industry matures. Adoption will be swift in emerging markets as newly affluent investors choose to invest first in ETFs, eclipsing traditional mutual funds.We also think new fund launches will likely slice the market into ever-thinner segments, especially in the emerging market and fixed income space. This means the industry will potentially have to watch for saturation and fund sponsors will increasingly look for ways to specialize to remain differentiated in the marketplace.

For Investment Professionals who want to learn more about where ETFs are headed, you can find SSGA’s latest research on SPDR University, including A Primer on Active ETF Due Diligence, Active vs Passive Redux: From Polar Opposites to Portfolio Complements and a case study on advanced beta.

1Morningstar Direct, as of 5/31/2015

This article was written by Michael Arone, CFA, Managing Director of State Street Global Advisors and the Chief Investment Strategist for the US Intermediary Business Group.