As we've noted, ETFs are a relatively new type of investment vehicle. The first ETFs were designed to provide investors with exposure to different indexes of equity securities like the Standard & Poor's 500 Stock Index (S&P 500). In recent years, ETFs have taken on a more complex investment visage, with a wide range of index-based, and even actively-managed, investment strategies.
Unlike mutual funds, ETF shares trade on a stock exchange and investors can buy and sell shares throughout the day at market-determined prices. This feature, plus potentially greater transparency and liquidity than mutual funds, lower costs and potential tax advantages, have made ETFs more popular with some investors than conventional mutual funds. These relative advantages have contributed to fast growth in the ETF market. The rapid growth is most prominent when compared to mutual fund growth of the same period. As we have noted, there are now approximately 1,600 exchange traded products with over $2.0 trillion in assets.
Against this strong growth over a short period, the critical question now for the ETF industry is whether the growth will continue? The last several years saw the closure of several entire ETF complexes, while new product launches have slowed. A 2014 ETF investor study found that about half of the respondents plan to boost their ETF holdings over the next year, and that as investors gain a deeper understanding of ETFs their confidence and assets in ETFs grows. At an ETF industry conference it was predicted that ETF assets would exceed mutual fund assets within 10 years. This prognosis was based in part by an increase in the use of ETFs by institutional investors.
Now, passive ETFs have become commonplace, and through a streamlined process, the formation, registration, and subsequent operation of these types of ETFs – those that track a conventional equity or fixed income index – has become relatively straightforward and quick to market. The ETF product universe will continue to grow and evolve for the foreseeable future. Stretching away from the core securities indexes are ETFs that track foreign currencies; ETFs that track indexes or benchmarks representing single commodities or diversified baskets of commodities; and ETFs that track precious metals. Certain ETFs track indexes on a "leveraged" or "inverse" basis. Since 2008 "actively managed" ETFs have entered the market. ETFs today may invest in very different types of underlying financial instruments and employ very different investment strategies, including investments in futures contracts, swaps, and other types of derivative instruments, than the ETFs initially brought to market. The counterpart to the complexity in types of ETFs is complexity in the state of ETF regulation. Product diversification and more unique products provide for different regulatory hurdles. Each new concept and class must assess additional regulatory considerations. This complexity is perhaps best witnessed by the fact that ETFs designed to track different benchmarks, but that may operate in very similar manners, are regulated under different laws and regulations by different federal agencies and self-regulatory organizations ("SROs"). We discussed the various agencies and SROs in our last post.
This widely varying regulatory landscape has significant competitive implications for ETF market participants. Why? We have not seen any formal studies done on this topic, but in our experience, the first ETF to market in a particular asset class or niche is the one that is ultimately successful. Consider the largest is ETF is also the first, despite other ETFs tracking the exact same benchmark. And, building assets has become perhaps the single most important factor in the ETF industry with respect to survival with the easiest way to accumulate assets is being first.
Accordingly, perhaps even more so given the anticipated continued strong growth in ETF assets, we find that as practitioners advising asset management firms and other sponsors of ETFs, we are expected in today's competitive environment to play a very different role than before. Going forward, we think that the effective ETF practitioners will be those who are prepared to counsel clients on the different types of ETF products that are now coming to market, and how the different ways these products are regulated may impact speed-to-market and development and operational costs, as well as a range of other competitive factors.
In summary, then, as we have pointed out in prior posts, having a well thought out investment objective for your new ETF is critically important, but understanding how that fund will be regulated, and what specific different approvals are required, is also important, especially in estimating the time from concept to launch.
We will continue to explore in this space the regulatory and competitive differences between funds and different types of products.
This article is presented for informational purposes only and is not intended to constitute legal advice.
