10 Thoughts From the 2016 Morningstar ETF Conference

The active vs. passive debate has now become a foundational discussion within the investment industry. Active funds still take the lion’s share of assets across all asset classes. However, an increasing regulatory and consumer focus on low-cost and performance are reasons that both institutional and retail investors have pulled back from actively managed funds in favor of passively managed funds.

Indexers see further growth for Smart-Beta strategies. Due to the increased usage of Smart-Beta strategies, the ETF industry is seeing a huge growth in factor investing; these factors have provided better risk-adjusted returns historically, and many believe that is likely to persist in the future due to behavioral biases and/or different investor constraints (e.g., ability to short or use leverage, time horizons). Examples of factors include small cap, value, momentum, low volatility, and quality. Given that single-factor ETFs typically outperform in specific market environments, there is an increased focus from issuers as well as investor appetite for multi-factor ETF strategies that are able to thrive in multiple market environments. An example of a multi-factor ETF is the SPDR MSCI Emerging Markets Quality Mix ETF (QEMM A-), which tracks an index of emerging market securities equally weighted between value, minimum volatility, and quality.

Fixed-Income Smart-Beta ETFs are beginning to attract greater attention. Income-oriented indexing is in demand, and there is investor appetite for more income solutions as evidenced by almost $43 billion in funds going into the Fixed Income ETF space in 2016.

Emerging markets ETFs will continue to see higher fund inflows in the near future for a variety of reasons. Emerging markets and developing economies, according to the IMF, are expected to expand at 4.1% in 2016 and at 4.6% in 2017. These growth forecasts are well above the 2.2% and 2.5% growth rates in 2016 and 2017, respectively, for the US economy. Besides higher growth rates, emerging markets also provide diversification benefits, attractive valuations, and dividends. Given that global interest rates are at low levels, especially in the developed world, investors are flocking toward emerging market ETFs for higher yield.

One of the most recent Smart-Beta innovations is ETF providers incorporating ESG principles (i.e., companies that adhere to exceptional/strong environmental, social, and governance practices). Two examples of such funds are the Columbia Sustainable US Equity Income ETF (ESGS A-) and the SPDR MSCI ACWI Low Carbon Target ETF (LOWC A-). Academic research indicates that investing in ESG principles is an excellent way of adequately managing investment risks, such as board accountability, as well as minimizing default risk.

The ETF industry is likely heading toward the path of all ETF-managed portfolios, given the low cost and liquidity features of the ETFs. However, investors should focus on longer-term ETF strategies. Investors may start by identifying their goals, whether that is retirement, down payments for a mortgage, or children’s education. The next step should be to set up a well-diversified portfolio using ETFs, which offer a broad coverage of assets. Costs are paramount in this decision-making process, as they can erode long-term returns through compounding over time.

Investor education has recently become more important due to the rapid expansion of the ETF product landscape in recent years. Product issuers, financial intermediaries such as advisors, and regulators are all among the key parties when it comes to offering investor education. Continued education on the potential benefits and risks of ETFs will likely minimize some of the surprises that investors may have. Consistently educating investors on the nuances of underlying indices, tracking errors, and implied liquidity will likely lead to better decision making by investors and will help prevent them from making rash decisions and departing from their initial investment plans. New distributional structures will also drive educational needs.

With information not readily available compared to the mutual fund world, ETFs present unique distribution challenges. ETF providers could improve their product development efforts if they are able to obtain more insight and greater transparency into who is using their ETFs and their rationale for investing in them. This could potentially lead to a better bundling of ETFs with other vehicles to provide investors with customized investment solutions.

Roughly 60 million Millennials continue to stay on the financial sidelines. Either they do not want to invest in the stock market at all, or they are skeptical and want to play it safe by investing small amounts or utilizing low-risk strategies. Millennials are cautious about the market, and with good reason. During their lifetimes, there have been two major recessions, the dot-com bubble burst, and the housing market crashed.

The ETF industry is rapidly evolving and will continue to do so over the next few years. A few ETF trends to watch for include ETF-managed portfolios, robo-advisors changing the financial advice landscape, and multi-factor investing and Smart-Beta Fixed Income products continuing to grow and evolve. Given the ETF proliferation and product innovation, investor education will remain a priority for the industry.