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The Labor Department’s “fiduciary rule” was designed to help retirement savers, but one of the biggest beneficiaries might be exchange-traded products, including ETFs and ETNs.
The new rules take effect April 10, 2017 and according to one estimate, the market could triple within a few years as a result of its implementation.
“It’s just that ETFs will see a bigger slice of that growing pie, with the immediate beneficiaries being the low-cost, low-risk index structure funds where flows have already been going.”
Frank La Salla, chief executive officer of BNY Mellon’s Alternative Investment Services.
“Because of the unique structure of ETFs, and because of advisers being held to higher standards, we think the market could grow exponentially. Going to over $5 trillion in assets seems pretty easy; we think it could top $10 trillion by 2020,” said Frank La Salla, chief executive officer of BNY Mellon’s Alternative Investment Services.
“This won’t be a zero-sum game. Both ETFs and mutual funds will grow as the pie gets bigger,” he said. “It’s just that ETFs will see a bigger slice of that growing pie, with the immediate beneficiaries being the low-cost, low-risk index structure funds where flows have already been going.”
Hitting $10 trillion would require the market for exchange-traded products (including both ETFs and exchange-traded notes, a product category used for trading unsecured and unsubordinated debt) to roughly triple over the next three years. At the end of August, there were about $3.38 trillion in global ETP assets, according to data from ETFGI, an independent research firm. ($2.41 trillion of that was in U.S. assets.) That represents growth of more than 18% from the previous year.
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ETF assets topped $1 trillion in 2009, but flows into them have accelerated in recent years, and the number of funds has skyrocketed. According to ETFGI data, there were 6,468 exchange-traded products at the end of August, 542 more than at the end of August 2015. In other words, more than one fund a day was launched over the past year, on average. (As the number of funds grows, so has the number of fund closures, as many fail to find a market.)
La Salla noted that the new rules dovetail with trends that are already benefiting ETFs, which have grown in popularity alongside a broad shift into passive investing.
Market participants are increasingly using index funds, which are pegged to a specific benchmark like the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.38% , and eschewing active funds, where the components are selected by an individual or team of managers. Not only do active funds carry higher fees than their passive equivalents, but the vast majority underperform over the long term, research has showed.
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According to data from Morningstar, passive funds saw inflows of $418.6 billion last year, while active funds saw outflows of $223.1 billion. That trend has continued in 2016, leading to a price war among the major asset managers. On Wednesday, BlackRock trimmed the fees of more than a dozen of its major index funds, bringing many of them a single basis point below similar funds offered by Vanguard, one of its chief rivals.
The standards set by the Labor Department require that the financial advisers and brokers who handle individual retirement and 401(k) accounts must act in the best interest of their clients, rather than recommending investments that although clients may be able to afford, may not be the cheapest or best options.
Broadly, many expect that the primary attributes of ETFs—the transparency of their holdings, their typically lower costs and greater tax efficiency—will lead to their being favored, especially over mutual funds that track similar benchmarks but are more opaque regarding their holdings, and which come with higher taxes and higher fees and commissions. In May, Morningstar estimated that “upwards of $1 trillion may move into passive investments” as a result of the rules.
“The fiduciary rule isn’t intended to bar products, but the adviser industry will look to products that offer greater transparency and disclosures,” said Rich Messina, senior vice president and head of investment products at E*Trade . “An ETF is about as straightforward as you can get with that.”
Not only would a $10 trillion ETP industry represent remarkably swift adoption of an asset class that is not even 30 years old—the first was launched in 1993, when State Street Global Advisors released the SPDR S&P 500 ETF Trust /zigman2/quotes/209901640/composite SPY -0.35% , still the biggest and most widely ETF—but it would nearly close the gap between ETFs and mutual funds, an asset category that has existed for decades longer.
In August 2016, there was $13.63 trillion in long-term U.S. mutual fund assets (excluding money-market funds), according to data from the Investment Company Institute, an amount that represented just 0.3% growth from the prior year.
Already, ETPs have surpassed hedge funds in size.
As of the end of the second quarter of 2016, there were about $2.9 trillion in total hedge-fund assets, according to the most recent HFR Global Hedge Fund Industry Report . Hedge funds have seen investors leave in droves, a trend driven by their high fees—they typically charge a 2% management fee and take a 20% cut of profits—and the fact that few fund managers can boast of sustained outperformance, especially when costs are factored.
“What we’re going to see in a world where returns are hard to come by is that the only thing that can be controlled is cost,” said State Street’s Mazza. “That doesn’t mean we’ll see the death of active management; on the contrary, I think this opens the door to active managers who can deliver solutions at reasonable fees while still adding value.”
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