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ETFs enjoy full range of drivers for growth

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The battle for dominance between the active and passive fund management industry took another turn this month with the news that 2016 saw the global ETF/ETP industry grow faster than the global hedge fund industry according to ETF data providers ETFGI.

ETFs came in with assets USD530 billion larger than the assets invested in the global hedge fund industry, and the company notes that this achievement is more significant as the ETF industry is just 27 years old against the 68 years old hedge fund industry. 

The total ETF assets at the end of 2016 sits at a record level of USD3.548 trillion invested in 6,630 ETFs/ETPs against HFR's figures for hedge funds, showing assets of USD3.018 trillion invested in 8,326 hedge funds.

Performance is deemed a key driver in ETF supremacy with the HFRI Fund Weighted Composite Index at 5.5 per cent over 2016 while the S&P 500 Index achieved 11.9 per cent. And hedge fund performance has struggled for the last six years according to the data.

It is of course in the fees' arena that hedge funds take their harshest battering. This year ETFs have cut their fees down to basis point figures with the average annual cost for ETFs/ETPs at 31 basis points, around a third of one per cent, while hedge funds struggle to get 2 and 20 per cent as in the old days but haven't achieved significant fee reductions.

Investor groups into ETFs are shifting too. In the US, the ETF investor community was originally dominated by retail investors, but studies are increasingly revealing institutions stepping up to dine at the ETF table. 

A new report from Greenwich Associates finds that institutional assets are flowing into ETFs as US institutions integrate ETFs into essential functions ranging from risk management and liquidity enhancement to the generation of income and yield in a challenging interest-rate environment.

The report found that some 47 per cent of bond ETF investors expected to increase their allocations to the fund in the year ahead, while investors were already investing an average 21.2 per cent of total assets in ETFs – up from the 18.9 per cent of total assets reported in 2015. 

Approximately half the institutions in the study used ETFs for liquidity management and nearly the same share employed ETFs in risk management or overlay strategies.

Other drivers included straightforward replacement of active managers with 38 per cent of institutional ETF users replacing other vehicles in their portfolios, including active mutual funds and derivatives positions.

The Greenwich report also found that institutions are using innovative ETF structures to address challenges in their portfolios. Institutions are turning to non-market-cap weighted/Smart Beta funds like Minimum-Volatility ETFs and Dividend/Equity Income ETFs to help navigate the challenges posed by low interest rates and increasing market volatility. 

The report found the share of institutional ETF users investing in non-market-cap weighted/Smart Beta ETFs up to 37 per cent in 2016 from 31 per cent in 2015, with 44 per cent of these investors planning to increase their allocations to the funds in the next year.

The survey also revealed that when conducting due diligence on a potential ETF investment, institutions considered four primary factors: the degree to which the ETF matches their exposure needs, liquidity/trading volume, the expense ratio of the fund and performance/tracking error. 

Brown Brothers Harriman's 2016 US ETF Investor Survey highlighted that the drive towards low cost investment has been a big contributor to the growth in ETFs. The US's Department of Labor (DoL) Fiduciary rule, portions of which are due to be enacted in April of 2017, requires advisers who oversee retirement accounts to maintain a fiduciary standard for their clients. The conclusion is that this is likely to lead to increased usage of funds with the lowest fees, which could be a big positive for the ETF industry.

Other broader trends that encourage ETF growth exist on their own, BBH finds, with even old school active mutual funds launching smart beta ETFs. And smart beta remains ever popular with 97 per cent of investors surveyed by BBH planning to maintain or add to their smart beta positions next year.

Here, the findings supported growing interest in emerging index methodologies, with the firm reporting that investors are gaining comfort in using multiple smart beta strategies such as minimum volatility and dividend oriented strategies to achieve certain objectives and exposures in client portfolios. 

And in Europe, ETF usage has grown on the back of a wave of new post global financial crisis regulation that seeks to give the investor the best possible and most affordable investment solution and to push as much trading as possible on exchange and away from the OTC markets.

The UK's 2012 Retail Distribution Review (RDR) started the push towards the new so-called robo-adviser type firms using ETFs on an RFQ basis, as a low cost investment solution for retail investors. Where the ETF industry had, in Europe at least, been dominated by institutions, suddenly the retail side is growing. 

Robo-advisers or web-based digital investment managers create fairly vanilla portfolios of ETFs with fixed exposures to risk and reward designed to suit the investor.

Using ETFs rather than mutual funds or equities has proved cheaper with one such firm, Nutmeg, estimating that this process has saved GBP1 million in one year in trading costs. 

And all of these developments in the industry rely upon and encourage greater education on ETFs. The wider range of people who take them up, the more the story is disseminated.

The ETF industry, which hits record levels of assets under management every month, looks set to continue on its path, sweeping away a great chunk of traditional fund management in its path. 

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