ETFs are moving from a phase of passive revolution to active evolution, according to a recent report from Citi. Scott Chronert, managing director and Citi Research’s US Equities Strategist, spoke to Global Trading to offer a deeper insight into the upcoming changes.
Rolling it back to the 1990s, Chronert explains the ETF journey so far. “ETFs started out mainly around the S&P 500, but then expanded into replicating nearly every underlying index that was available to most investors,” he tells Global Trading. “That’s the revolution – you could now trade the S&P 500 or the NASDAQ 100 index as a ticker.”
Over the years, an increasing number of use cases have been identified for the ETF toolkit, including traditional long-only investing and hedging. However, Chronert shares that “as we hit the last several years, we’ve made the point that nearly every passive index has now been replicated. Does that mean that the ETF industry is hitting more of a mature phase?”
“The ETF industry is adaptive and responds to changing conditions in the market,” he confirms. “We’ve seen the ETF industry move down an incremental growth path of more smart data products, and along the way we’ve begun to see the early phases of a move down the traditional asset path.”
Hence, the active evolution phase. “The industry is now moving from this historic focus on passives to smarter approaches to passives, and is now going down a much more traditional, actively-managed path. That puts them head-to-head with the traditional actively-managed mutual funds and the institutional investor world.”
Looking ahead, Citi’s report stated its expectations that traditional mutual funds will cede a significant portion of their AUM currently not attached to defined contribution pension plans. Between US$6 and US$10 trillion is at risk of ETF displacement, it continued, and while assets attached to defined contribution retirement accounts will experience this at a slower rate they are not immune to the evolution.
Ageing out
One reason for the move away from mutual funds is a changing demographic. The younger generation is more likely to lean towards ETFs, Chronert explains, in part because this is the fund type that has been advertised the most to them as they began their investment journeys. Additionally, Citi notes an uptick of interest in stock selection among investors over recent years, after a decade of passive focus following the global financial crisis.
“For the younger cohort, ETFs have become a bigger [force] in the market over the past 10 years, particularly post-GFC,” he says. “We think the natural demographic shift should be another tailwind to what’s been happening anyway as we move down the devolutionary path from passive to active.” The inevitability of the passage of time suggests that mutual fund opportunities will weaken as wealth is passed down; already, over the past two decades the number of mutual funds has stayed static while there are “new product launches every other day” when it comes to ETFs, Citi’s report states.
Dual class structure
Citi’s report draws attention to the expiration of Vanguard’s patent on structuring ETFs as a distinct share class of their existing mutual funds. “They essentially had one big fund that was replicating an index, and you could have a mutual fund version or an ETF version of the same fund,” Chronert explains. Since the May 2023 expiration, eight firms have filed with the SEC for share class relief, with some wishing to offer this for their active mutual funds.
“What we’re suggesting is that if the general path is away from mutual funds to ETFs, with a dual share class structure like this you don’t have to shift. It’s all part of the same fund. That’s part of why we don’t think you’ll get a wholesale trend where everything moves from mutual funds to ETFs, because this dual class structure lessens the incentive to do that,” Chronert notes.
Concluding its report, Citi states that while ETFs are increasingly popular, “mutual funds will find their own means of adapting and differentiating. Ours is an industry that is inherently entrepreneurial, and which has shown the ability to adapt to, and capitalise on, change”.
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