11 Takeaways From the 2017 Morningstar ETF Conference

The ETF-centric event presents strategies and portfolio insights from some of Wall Street’s leading finance professionals.

In this article, we present 11 takeaways from the conference.

With more than 1,900 ETFs in the United States alone, the importance of doing due diligence has never been greater. Investors must consider a myriad of factors before constructing their portfolio, including their goals, risk tolerance, liquidity needs and tax considerations. Carefully evaluating costs, product structure and the fund provider itself are critical for ensuring the long-term success of your investment strategy. Due diligence will remain an essential feature of ETF investing, especially as the size and complexity of the market grow.

In an increasingly complex global economy, factor models that take account of the broader economy and fundamental analysis are likely to proliferate. The growth of smart beta strategies has shined the spotlight on so-called value and quality factors, which rely on fundamentally weighted index construction. A fundamentally weighted index often exhibits a correlation between economic performance and the asset’s return. Although this has its benefits, it often leads to behavioral biases that can negatively impact returns. It will be interesting to see how economic modeling evolves in the coming years to factor a synchronized global recovery and the gradual unwinding of ultra-loose monetary policies.

Multifactor ETFs are poised to take off as investors look to smart beta strategies in pursuit of greater diversification. Multifactor approaches diversify among various factors to help investors minimize the risk of any one factor, thus helping to build a more diversified portfolio. According to Morningstar, there were nearly 200 multifactor ETFs available in 2016. Some of the most prominent examples of multifactor ETFs are iShares Edge MSCI Multifactor ETF (LRGF A-) and SPDR MSCI USA StrategicFactors ETF (QUS A).

ETF investing has both costs and risks. To explore them, check out: The Hidden Risks and Costs of ETFs.

Smart beta investing has grown rapidly in recent years. This has trickled down to the ETF sphere, where factor investing is gaining in popularity. At the same time, these strategies come with added risks, especially as it pertains to ETFs. For starters, the opportunity for excess returns offered by smart beta comes with extra risks. This is true no matter the construction methodology one uses. At the same time, factor exposures often lack internal logic because they are heavily focused on past performance. This can lead to overweighting specific industries, leaving investors exposed to larger unintended risks. However, there is little evidence to suggest that smart beta investing is on the decline.

For a full list of Smart Beta ETFs, click here.

Smart beta strategies have gained attention in recent years, but have failed to proliferate in the fixed income sector. Liquidity constraints, a lack of historical data and high transaction costs are some of the major pitfalls of smart beta investing. Despite these challenges, we have seen a gradual influx of smart beta strategies in recent years. WisdomTree Canada recently announced the launch of two smart beta fixed income ETFs, Yield Enhanced Canada Aggregate Bond Index ETF (CAGG) and Yield Enhanced Canada Short-Term Aggregate Bond Index ETF (CAGS).

Like ETFs, small cap stocks tend to have higher growth potential than their large-cap counterparts. However, that additional growth potential likely comes at the expense of greater volatility. That being said, growth conditions for small caps have crystallized since the 2016 U.S. presidential election. The promise of financial deregulation and fiscal stimulus suggest that smaller companies will have a more favorable economic environment they need to grow. One of the most promising small cap ETFs is the iShares Russell 2000 Growth ETF (IWO B), which tracks the popular Russell 2000 Index.

For a full list of ETF Database Categories, click here. For a full list of ETF Types, click here.

Both advanced and emerging markets are expected to see higher fund inflows in the future as portfolio managers look beyond U.S. borders. In fact, U.S. funds are seeing their longest run of outflows in over a decade as investors look to capitalize on the rebounding economies of Japan and Eurozone. At the same time, Wall Street banks HSBC, Citigroup and Morgan Stanley are warning that a domestic downturn is coming.

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Liquidity is an important consideration that will only grow in importance as investors continually seek alternative investment vehicles. While ‘alternative investment’ can mean different things to different people, it is usually designed to provide positive returns that are not correlated with major asset classes. ETFs are making it easier for investors to gain exposure to these alternative investments, hence the growth of ‘liquid alternatives.’ The liquid alt universe remains quite small, with one estimate giving a count of only 35 U.S.-listed ETFs. While these investment vehicles provide good opportunity, their uneven distribution means investors must proceed with caution. The segment leader is the IQ Hedge Multi-Strategy Tracker ETF (QAI A-), which seeks to emulate hedge fund returns across various strategies.

After losing momentum in 2016, ETF managed portfolios are gaining traction once again. By the end of the first quarter of 2017, there were 950 ETF managed portfolio strategies with total assets of nearly $100 billion. That’s a 17.6% increase from the previous quarter. This trend is likely to continue as fund managers look to capitalize on the low cost and liquidity features offered by ETFs. For many investors, managed portfolios make a good addition to their investment strategy, provided that the costs and benefits align with their underlying goals.

ETFs linked to environmental, social and governmental (ESG) strategies are often difficult to quantify since there is no consensus on what ESG actually means. Poor disclosure, a lack of industry-wide definition and no consensus are just some of the main challenges holding back ESG integration. The future of ESG appears to be equally murky, given the general divergence of opinion on what this broad investment approach entails. One of the clearest criteria for ESG investing is offered by Barclays Women in Leadership (WIL B-), which invests in companies with women as CEOs or board members.

To learn more about the opportunities and challenges surrounding ESG, check out: Why ESG Investing Needs More Precision and Clarity.

The popularity of ETFs has created intense competition among issuers. This has resulted in an escalating fee war that has both positive and negative consequences on the market. One of the main consequences is a ‘race to the bottom’ scenario that is currently being played out with respect to ETF expenses. Issuers have thus prioritized value-added services to attract investors. Resolving distribution challenges by bundling ETFs with other investment vehicles is a potentially valuable method that issuers can use to ensure future growth.

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