Thought Magazine

The Next Stage in the Growth of ETFs

ETF sponsors are aware that, while there has been healthy advisor usage of ETFs in the last few years, opportunity still exists to grow the market.

They are the sine qua non for investment managers today. In the last decade, the growth of U.S.-based exchange-traded funds (ETFs) has significantly exceeded every other asset management category.

Global ETF assets stand at a record US$2.2 trillion (as of Q3 2013), with more than 70 percent, or $1.56 trillion, invested in U.S.-listed products. Furthermore, momentum does not seem to be slowing; by third quarter 2013, ETFs experienced $130 billion of inflows year-to-date.1

In the more than 20 years since the product's inception, ETFs have been used by most managers as a purely passive tool, designed to provide broad market exposure. Though ETFs continue to garner significant flows for this use, continuous product innovation and a steady progression toward value-added strategies have helped fuel recent expansion.

Today—actively managed ETFs with full disclosure

Some market observers now point to actively-managed products as the next source for new inflows into ETFs. Today, actively-managed ETFs comprise a small sliver of the overall ETF pie; to date, a mere 62 actively-managed ETFs have been launched with roughly $14.5 billion in assets and represent less than one percent of total ETF assets in the U.S. as of third quarter 2013.2

We believe that as actively managed ETFs accumulate more assets they will begin to compete with traditional mutual funds for market share. The most significant driver would be the expansion of active ETFs into new channels and new customers for investment advisors.

The case for an actively-managed product in an ETF wrapper is both simple and attractive: it proves more tax-efficient and cheaper with intraday liquidity. Until now, however, alphagenerating mutual fund shops have been hesitant to enter the space, a fact many attribute to the requirement to provide daily portfolio transparency. Undoubtedly, traditional active managers who attract assets based on their stock-picking capabilities would be averse to unveiling their proprietary research. In any event, it is true that fixed-income strategies have so far been the most successful in an actively-managed ETF wrapper. The front-running of bond trading strategies is not practical and does not expose managers or the funds to such practices.

On the table—new proposals for the SEC

There are a few proposals from asset managers currently before the SEC that, if adopted, would limit the disclosures that ETF sponsors would be required to make. Some propose that ETF sponsors be permitted to disclose their portfolios on a less than daily basis. Others look to limit disclosure to a subset of the overall investment holdings. Each proposal attempts to solve the same challenge of trying to protect portfolio management security selection while providing enough transparency so that market makers can make efficient markets.

One such proposal is Precidian Investments' patented ActiveShares concept. This proposal utilizes a blind trust between the ETF and the authorized participant seeking to redeem shares. When the redemption is transacted, the ETF would deliver in-kind, high cost basis, tax lots of portfolio securities out of the fund to the blind trust. The blind trust would then liquidate these securities and deliver the cash to the redeeming authorized participant.3

Precidian's process allows an ETF to maintain a discretionary veil over their portfolio holdings—an attractive option for alpha-generating managers—while realizing the tax benefits associated with in-kind redemptions. In addition to the use of blind trusts for redemptions, Precidian's proposal only allows creations for cash similar to a mutual fund. An actual intraday net asset value would be disseminated every 15 seconds, which Precidian believes will enable market participants to hedge trading exposures and permit the efficient trading of the ETF shares closely tracking NAV within a range similar to that experienced by existing ETFs. The proposal also provides a small allotment redemption option to allow shareholders to redeem shares at NAV directly with the fund. Unlike existing ETFs that disclose the identity and amount of a fund's securities, which form the basis for the NAV calculation each business day, ActiveShares would only disclose portfolio investments once per quarter. This would be consistent with the current disclosure requirement for '40 Act-registered mutual funds.

Additional SEC filings

Both T. Rowe Price and Vanguard have filed exemptive applications with the SEC to offer ETFs with partial transparency. Vanguard has proposed to release a representative sample of the fund holdings that will track the return of the ETF share class. Vanguard's application provides statistical evidence that the tracking error between the daily return of the representative sample basket and that of the ETF shares is within the range of tracking error seen in existing index-based ETFs.4

T. Rowe Price's filing suggests that their proposed ETF will disclose a daily hedge portfolio in which each fund will consistently invest at least 80 percent of its total assets. Additional data points detailing the difference between the hedge portfolio over a rolling, one-year period would be made available to provide traders with additional tools. Creations and redemptions would generally be transacted in-kind via the delivery of the hedge portfolio.5

Finally, Eaton Vance has filed an exemptive relief application with the SEC to launch its patented exchange-traded managed funds (ETMFs). As their name suggests, ETMFs would trade on an exchange like existing ETFs; however, those trade prices would be linked to the fund's end-of-day net asset value. The final settlement value of on-exchange executions would not be known until the end of the business day, after the net asset value has been calculated.6 This hybrid mutual fund/exchange-traded fund approach would allow managers to maintain a discretionary veil over the portfolio investments following the mutual fund quarterly disclosure requirement.

ETFs in 401(k) plans

Some market observers point to the fact that ETFs are positioned to enter the wider retirement funds market. Today, mutual fund assets make up more than half of the roughly $5 trillion in 401(k) market assets (as of year-end 2012).7 Retail investors own approximately 55 percent of all ETF assets in the U.S. Yet, defined contribution 401(k) plans comprise barely one percent of ETF assets.

Mutual funds have long maintained a stranglehold on the 401(k) market. This is due in part to technological investments; sponsor record-keeping platforms were built and designed with the mutual fund structure in mind decades ago. Nevertheless, the benefits of having an ETF offering in the stable of a retirement plan are becoming quite clear. Generally speaking, ETFs are a cheaper alternative to mutual funds.

The primary hurdle preventing more widespread adoption is the fractional share conundrum. ETFs trade intraday at quoted prices in whole share increments, unlike mutual funds that trade in batch orders at the end of the day and can allocate fractional shares.

TD Ameritrade feels they have a solution that has solved the fractional share challenge. When a plan participant purchases an ETF, TD Ameritrade funds the fractional share amounts by rounding up to the necessary dollar amount to purchase a whole share. When a participant sells their position, TD Ameritrade sells the position and receives the proceeds of their stake in the fractional share.8

While the timing of its rollout is pending, Charles Schwab has announced the intention to launch an ETF-only 401(k) plan for providers.9 The plan would offer commission-free trades for a host of ETFs, allaying any potential concern over high transactional costs. If successful, other plan sponsors could follow suit as investors demand greater flexibility with retirement options.

Understanding today's advisor market

ETF sponsors are aware that, while there has been healthy advisor usage of ETFs in the last few years, opportunity still exists to grow the market. There is definitely room for an increase in new advisors using ETFs as a core asset allocation tool, as well as for current advisors increasing their allocations to ETFs.

The overall trend in the advisor market has been toward an uptick in fee-based relationships. If that continues, late-adopting advisors should no longer have the same affinity toward mutual funds they once had in the old commission-based advisory relationship. Furthermore, a great benefit of ETFs is that advisors are able to use them as a core asset allocation tool in order to diversify client investments to build an active portfolio. They can do this either through direct investment or by utilizing ETF strategies that perform the allocations.

Some market observers point to the fact that ETFs are positioned to enter the wider retirement funds market.

Sponsors are capitalizing on this opportunity in the advisor market by offering tools to educate advisors on the mechanics of ETFs and how to effectively measure the true cost of ownership. Understanding the factors beyond the management fee that drives an ETF's cost basis—such as the bid-ask spread and liquidity associated with the product—helps advisors better compare similar funds.

Building a greater awareness of ETF features and benefits will only help future widespread adoption within the advisor community.

1 BlackRock, "ETP Landscape: Industry Highlights," September 30, 2013, Weblinking Icon.

2 Tom Lydon, "New Wave of Active ETFs Could Come from Mutual Fund Providers," September 29, 2013, Weblinking Icon.

3 U.S. Securities and Exchange Commission, "In the matter of the Application of Precidian ETFs Trust; Precidian Funds LLC; and Foreside Fund Services, LLC," January 25, 2013, Weblinking Icon.

4 Matthew F. Cohen, "ETF Confidential: A Survey of Non-Transparent Actively Managed ETFs," The Investment Lawyer, June 2012, Weblinking Icon.

5 U.S. Securities and Exchange Commission, "In the Matter of T. Rowe Price Associates, Inc. and T. Rowe Price Equity Series, Inc.," September 23, 2013, Weblinking Icon.

6 U.S. Securities and Exchange Commission, "In the Matter of Eaton Vance Management and Eaton Vance ETMF Trust," September 12, 2013, Weblinking Icon.

7 Cory Banks, "Has Schwab Cracked 401k Code For ETFs?," June 24, 2013, Weblinking Icon.

8 Hung Tran, "TD Ameritrade: ETFs In 401(k)s Now Live," October 31, 2013, Weblinking Icon.

9 Darla Mercado, "Schwab ETF platform for 401(k)s hits regulatory speed bump," October 7, 2013, Weblinking Icon.

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Thought, 1Q 2014


Jason Ronca Jason Ronca
ETF Product Executive
J.P. Morgan Investor Services

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