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ETFs need to grow assets to challenge mutual funds, says Deloitte

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With half of all exchange-traded funds falling short of the USD50m minimum net assets required to maximise profitability, attracting capital will be key to remaining competitive and potentially challenging mutual funds’ dominant market share, according to a paper by Deloitte.

“For retail investors hurt by market volatility over the last year, an ETF may be more appealing longer term than actively managed assets like mutual funds. When this perceived safety net is coupled with the tax efficiencies that are attractive to retail investors, it appears the stars may be aligning to end mutual funds’ 69-year dominance,” says Cary Stier, Deloitte’s US asset management services leader. “But in order to execute on this opportunity, ETFs will have to expand investor friendly attributes beyond transparency and low costs to compete for a share of the asset influx.”

According to Deloitte, several factors could enable ETFs to attract additional capital and become more profitable.

They should link to less exotic indices. Some of the best performing ETFs are linked to less exotic indices, such as commodities and equities. The data shows exotic funds, on average, have not performed as well as regular ETFs. This is not to say exotic funds have not performed well, but exotic ETFs are difficult for regular investors to understand. In other words, the simpler, the better. Also, simpler betas are cheaper than their more exotic counterparts.

ETFs should focus on indices with long-term appeal. There are a number of ETFs that are launched to benefit from a current market situation. Inverse financial sector ETFs, for example, profit from the ailing financial sector. However, according to Deloitte, most investors recognise that these ETFs have a limited shelf life. Being linked to an index with a long-term appeal is usually more attractive to investors, particularly retail investors.

In addition, ETFs should increase their appeal to 401(k) investors. The barrier for 401(k) funds investing in ETFs is its higher costs compared to index mutual funds. Given that 401(k) assets will probably reach USD7.5trn to USD8.5trn in 2015, ETF sponsors need to make themselves 401(k) friendly to tap into this huge pool of assets that primarily invests in mutual funds.

Deloitte says ETFs should become more retail-investor-friendly. When small investors buy ETFs, they incur commission costs, as well as the bid-ask spread. These costs usually make the difference between small investors putting their money in index mutual funds or ETFs. While commissions and bid-ask spread may not have a large impact on big investors, it is significant for investors who put in small but consistent sums of money. In essence, ETFs will have to maintain their “good” characteristics but mimic index mutual funds.

The ETF industry should keep itself institution-friendly, the paper says. The rise of ETFs is mainly attributable to institutional investors, such as hedge funds and pension funds. These funds were drawn to ETFs because of their low cost, risk diversification and efficient beta. Another reason for large investors to be drawn to certain ETFs is their strong liquidity.

Finally, Deloitte says ETFs must ensure low tracking error. The tracking error is the difference between the net asset value of an ETF and its benchmark. Typically, the simpler the benchmark, the lower the tracking error. A lower tracking error is also one of the primary determinants of choosing an ETF.

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