Rapid ETF Proliferation and the Impact on Financial Markets

The growth and widespread adoption of ETFs have important implications on the financial markets, and it is up to investors to determine whether the pros outweigh the cons. On the positive side, ETF proliferation means more investing opportunities at a lower cost, helping investors diversify their portfolio at a more affordable rate. Increased availability of ETFs also means greater product innovation in both fixed income and liquid alternative assets, as well as the development of goals-based portfolio solutions.

By the end of 2015, there were 4,396 ETFs available worldwide. That represents an increase of 47% over the previous five years. Use our ETF Screener tool to screen over 1,900 of these ETFs by various criteria including dividend yield, asset class, issuer, performance and investment objective.

Global ETF assets under management approached $3 trillion in 2015, a gain of 113% over five years.

On the downside, the rapid spread of ETFs also means a greater consolidation of the ETF issuer space, increased market regulation and the need for greater investor education. This environment raises the premium for due diligence on the part of ETF issuers, regulators and investors.

Below, we break down these advantages and disadvantages in greater detail, while also elaborating on others.

Lower Costs

ETFs are widely regarded as one of the most affordable investment vehicles in the financial markets. When passively managed, ETFs have much lower expense ratios compared to other managed funds. For example, ETFs are not subject to the same management fees, accounting expenses and other service fees that typically characterize mutual fund investment, making them more cost-effective over the long run. ETFs are also highly tax efficient. This means investors save money not only while managing the fund, but also when cashing it out for profit.

Product Innovation

A rapidly expanding market is also ripe with innovation. This characterizes today’s ETF industry, which is witnessing a proliferation of fixed income and liquid alternative asset classes. Liquid alternative strategies have seen huge capital inflows since the financial crisis for their ability to provide diversification, risk-adjusted returns and risk mitigation. Fixed income investing with active ETFs are also growing in popularity, as investors look to tap into a global bond market valued at more than $100 trillion.

More Strategies and Choice

ETF proliferation also means more product choices and strategies for investors. There are literally thousands of ETFs to choose from and a myriad of strategies to help investors achieve their financial goals. Today’s ETF market offers significant flexibility in implementing various investment strategies associated with asset allocation, diversification, cash management and hedging.

Goals-Based Portfolio Solutions

Since ETFs serve such a wide market, there is a growing emphasis on developing portfolio solutions that meet investors’ unique goals. One example is the Low Volatility High Dividend Index, which is designed to track the performance of securities that have historically provided a combination of high dividend yields and lower volatility. Other examples include ETF-managed portfolios that have more than 50% of portfolio assets invested in ETFs.

Retirement Market Penetration

ETFs are also keeping pace with the growing trend toward retirement planning. The increased emphasis on retirement led to the development of Retirement Date ETFs, which provided a one-stop shop for investors planning to retire on a certain date. Although this segment was shut down, it may still offer untapped opportunity in a market becoming increasingly concerned about securing retirement wealth.

ETFs Outside the United States

ETFs make powerful investments because they offer exposure to global markets. As emerging markets in Asia, Latin America and Africa continue to grow, ETFs offer a safer and more affordable strategy for accessing unique global opportunities. These new markets will accelerate due to tax and legal restructuring as well as the emergence of offshore fund domiciles.

Robo-Advisory Platforms

Robo-advisors are an emerging platform based on proprietary algorithms that administer an investment portfolio. Robo-advisors provide another value-added service for investors looking for a blend of automated and personalized portfolio management at a reduced cost. They typically exhibit lower fees than human investment advisors and automatically rebalance portfolios based on changes in asset categories. Read How Will Robo-Advisors Impact the Future of Investing to find out more on how robo-advisors are disrupting the traditional financial advisory model.

Consolidation of ETF Issuers

As ETFs proliferate, the number of competitors will likely decrease due to consolidation. This process will occur at a faster rate as robo-advisors and other low-cost portfolio solutions continue to grow while margins decrease. Like any other industry, investors tend to benefit more from a highly competitive market. This environment is at risk as the industry expands at such an accelerated pace.

Low Value-Additive Smart Beta Solutions Will Suffer

As the industry consolidates, smart beta solutions that provide a hybrid between passively managed portfolios and more active approaches could provide less value to investors. The loss of smart beta would be a strategic blow to the industry, since these solutions look past traditional ETF index rules tied market capitalization.

Greater Need for Investor Education

ETF investing provides an opportunity for lifelong learning, but too much of anything is never good. With thousands of ETFs already in existence and many more coming down the pipeline, it will become increasingly difficult for investors to keep track of the myriad of ETF products, strategies and regulations, not to mention the launches of new products and closures of old ones. This will place a greater premium on understanding how these assets are to be used and under what conditions.

Greater Need for Due Diligence

One of the side effects of a rapidly expanding industry is the need for due diligence among all parties involved in the market. This includes ETF issuers, regulators and investors themselves. This raises the issue of regulatory compliance, especially around leveraged and derivative products. Due diligence becomes increasingly complicated in a market with thousands of products.

Financial Advisory Model is Changing

Every aspect of the financial advisory industry is changing, and there’s reason to believe the proliferation of ETFs is speeding up the process. Services, marketing and distribution models are constantly evolving to keep pace with changing demographics, such as the bifurcation of Millennials and Baby Boomers. Whereas Millennials are increasingly demanding novel investment strategies, such as robo-advisors, Baby Boomers are preoccupied with retirement planning and safeguarding existing wealth. Naturally, financial advisors want to appeal to both (as well as other) markets, and are adjusting their service model to better serve these segments.

Industry analysts have mixed views about the growth of robo-advisors, as well as the prevalence of algorithm-based strategies among financial advisors. That’s because most robo-advisors are utilizing the top 300-400 ETFs in AUM for their needs since they cover most of their portfolio goals and can be had at a very low cost. The remaining ETFs, which number in the thousands, do not add significant value to the majority of investors, as evidenced by their low trading volume and overall AUM. Many of the remaining ETFs are also extremely complex and fill extremely niche areas of the ETF market.

For example, use our Head-to-Head Comparison tool to compare and contrast ETFs with the largest AUM, such as the SPDR S&P 500 (SPY A), to ETFs with the lowest AUM, such as DB Commodity Long ETF (DPU C+) using . The former has over $212 million under management, whereas the latter has around $400!

ETFs offer investors one of the most compelling opportunities to achieve their financial goals, but their rapid proliferation also has several drawbacks that must be considered. For a deeper breakdown of the pros and costs of exchange-traded funds, read The Hidden Risks and Costs of ETFs. For more ETF news and analysis, subscribe to our free newsletter.