The ETF industry has rapidly evolved over the past nine years. There were roughly 750 ETFs in 2008; currently, there are nearly 2,000 ETFs competing for more than $2 trillion in assets under management in the U.S.
In terms of size and growth, very few asset classes compare to exchange-traded funds. In the span of about 12 years, the ETF industry has grown from a paltry $417 billion to $4.4 trillion. Inherent advantages such as flexibility, portfolio diversification and lower costs have made ETFs a modern-day staple of investors’ portfolios.
Projections of assets under management show the ETF industry isn’t finished growing just yet. According to Ernst & Young, more than $7.6 trillion will be held in ETFs by 2020.
We have gained valuable insights on the evolution of the industry during our time at the 2018 Inside ETFs Conference. From the perspective of advisors, five core themes stood out as particularly relevant given the current economic and financial climate.
Read Insights from the Inside ETFs Conference: Investor Edition where we delve into our important takeaways for investors.
1. Understanding How ETFs Work Regardless of Size
Portfolio managers often get sidetracked by an ETF’s total size rather than looking at the core characteristics of the fund. There are several best practices for ETF trading, and none rely solely on looking at the fund’s total size. Regardless of how many assets are held under management, an ETF must be chosen on the basis of its risk profile, past performance, fund makeup and overall fee structure. An understanding of the broader economic and financial climate impacting the asset is also critical.
Factors such as ETF liquidity are also vital for measuring the fund’s efficiency. The most effective sourcing liquidity strategies reflect evolving market conditions. ETFs are at least as liquid as the underlying assets they hold, which makes the concept of implied liquidity equally important.
2. Robo Advisors
Advances in artificial intelligence have led to a sharp rise in robo-advisors, a trend that is expected to intensify in the future. Robo-advisors, which are essentially investment products driven by automation, could manage up to $1 trillion by 2020 and $4.6 trillion by 2022, according to BI Intelligence.
Robo-advisors are popular because they essentially use a questionnaire to understand a client’s risk and return expectations before employing a strategy with that information. This process is already offered by leading investment firms, as well as core robo-advisory firms like Betterment, Wealthfront and Wealthsimple.
The growth of the Millennial investor will likely expedite the adoption of robo trading strategies. But research shows it isn’t only younger generations that are attracted to automation; even baby boomers are beginning to utilize mobile devices, which puts them in a better position to capitalize on digital investment strategies.
To learn more about robo-advisors, read ETF-Friendly Robo-Advisors. To find out how robo-advisors may impact the future of investing, read How Will Robo-Advisors Impact the Future of Investing.
3. ETF-Only Portfolios
The growth of ETFs as an asset has made it possible to promote ETF-only portfolios. ETFs continue to offer broad diversification benefits in global markets, and can be constructed on the basis of various risk profiles. In general, ETF-managed strategies have more than 50% of portfolio assets invested in such funds. Of course, the exact breakdown of ETF vs. non-ETF assets can vary significantly based on the portfolio’s underlying goals and risk tolerance.
Although ETFs continue to make up a growing share of portfolios, the focus shouldn’t be on how many funds a portfolio can hold but on capturing the underlying assets the investor needs. In many cases, ETFs are the best vehicles for getting that exposure, but this isn’t always the case.
4. Pitfalls in Smart Beta Investing
Smart beta has garnered a lot of attention in mainstream investment circles, as portfolio managers have sought to look past traditional index construction methodologies. Although smart beta has surged in popularity since the financial crisis, the strategy has several pitfalls that portfolio managers are slowly realizing.
For starters, it is not abundantly clear which smart beta offers the best strategy. After all, index construction is highly subjective and there are multiple variations for achieving the desired results.
Suppose you choose the right blend of index construction tools, the strategy you employ will likely mean assuming excess risks. That’s not really a criticism of smart beta, but it bears repeating that any strategy designed to generate excess returns also means assuming more risks. Given the euphoria surrounding smart beta, this strategy isn’t always apparent.
Smart beta strategies may sound good on paper, but they often lack internal logic given that the factors are based on past performance. These strategies often lack an investigation of the economic reasons behind an asset’s performance, which can lead to undesirable allocation.
5. Portfolio Management in a Low-Return Environment
As the bull market enters its ninth year, few investors are equating the present with a low-return environment. However, experienced portfolio managers know it will become increasingly difficult to sustain the market’s bull run since President Trump was elected. Asset manager Vanguard recently predicted a growing likelihood of a major stock market correction in 2018.
The purpose here isn’t to speculate about when the market will correct, but to acknowledge that high returns will become more difficult to justify as the bull market matures. In this environment, portfolio management strategies that utilize dividend stocks or defensive funds could be well positioned to navigate through potential market downturns.
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