July 11, 2021

Monday Morning Memo: Why ETFs are the Future of the Fund Industry!

by Detlef Glow.

A number of market observers, including myself, have stated that ETFs have written a true success story over the last two decades and are set to continue this in the future. Even as this seems to be somewhat intuitive, these statements often miss a rationale why the trend toward ETFs will continue. Within this article, I want to shed a light on changes in consumer behavior as a driver for the growth of ETFs, since the COVID-19 pandemic has changed the behavior and expectations of consumers.

Even as I was always positive for the future of ETFs, I think that the COVID-19 pandemic will accelerate the trend toward ETFs. Generally speaking, the rise of delivery services such as Amazon have changed consumer behavior from going shopping in a mall or a single shop to ordering things from their computer, mobile phone, or tablet.

At the same time, Amazon raised the bar for their competitors with same-day delivery for a number of goods ordered on its platform. This also changed the expectations of consumers for their suppliers in general. Even as short delivery times were a nice gimmick before the outbreak of the COVID-19 pandemic, it became a very convenient feature which consumers found somewhat necessary when economies went into lockdowns.

From my point of view, these expectations will not change and consumers will start to think that fast delivery is a must for any type of goods and services, and real-time trading is one of the key features of ETFs. In addition to this, the COVID-19 pandemic let to a higher online trading activity for investors around the globe, which may not change in the future. This is a trend that is also in favor of ETFs, since mutual funds are in general not traded on exchanges.

Another important point that may help to understand why ETFs will have a bright future can be seen in the change and the use of technology. While the majority of discussions around ETFs are based on the active versus passive debate, one can also see ETFs as a technology upgrade of mutual funds. This is true, as ETFs are a different type of mutual fund which have some key features, especially with regard to fund distribution, that were not needed when mutual funds started to get traction with retail investors in the 1950s and 1960s.

This process can be compared with the evolution and usage of TV sets, which also became popular during the 1950s and 1960s. At that time, TV sets used to be expensive and heavy goods with a small black-and-white screen, and the number of TV stations was quite limited. Nowadays, TV sets are comparably cheap and have large 8k Ultra HD screens that can display more colors than the human eye can see. In addition to this, modern TV sets are so-called smart TVs which are permanently connected to the internet and allow the user to watch their favorite TV show or series at any time. With the increasing popularity of TVs in the living rooms of families around the globe, there was a massive increase of the number of TV stations and the variety of programs. A number of these TV stations still stick to traditional broadcasting times for their most watched programs and restrict the online availability of these shows. This means they are also limiting the number of viewers. This also explains the success of streaming services such as Netflix, which have started to compete with traditional TV stations with on-demand services. This enables their customers to watch their favorite TV show whenever they want.

One may ask what this story has to do with the fund industry, but the relevance of this becomes quite obvious if one sees mutual funds as TV sets and the broadcasting companies as fund promoters, while ETFs are the 8k UHD TV sets and their promoters are the providers of streaming services. To put a bit more flesh on the bones here, mutual funds are rather expensive investment vehicles that haven’t changed much since their inception, and in most cases, are not available on every brokerage platform. In addition to this, mutual funds can’t be traded at any time, so there is often a delay of one or two days between the order of a fund and the respective execution. Conversely, ETFs are transparent low-cost products which can be traded immediately in any online account with a connection to an exchange. This means that ETFs can be seen as very efficient vehicles for fund distribution, since their promoters can reach every investor with a respective online account. In addition, listing on an exchange makes the promoters of ETFs also independent from any kind of brokerage platform.

That said, the next question might be why do the promoters of active funds deny plans of launching ETFs instead of listing all their products on an exchange? The first and most obvious reason for this is the fact that a listing on an exchange may compromise the existing relationships between the fund promoters and their brokerage platform and/or financial advisors. From my point of view, the more important reason for the reluctance of fund promoters can be seen in current fund regulations. While ETFs have to disclose their portfolio holdings in a quite frequent manner, mutual funds only have to publish their holdings in their annual and semi-annual reports. In addition to this, active fund managers see the holdings of their portfolios as intellectual property and are therefore quite reluctant to publish their portfolio holdings.

I assume that the promoters of actively managed funds will start to use the ETF structure as distribution wrapper once regulators around the globe align the reporting duties for holdings disclosure between mutual funds and ETFs. As we have already seen that first regulators are rethinking their policies to allow semi-transparent ETFs, I could imagine that ETFs will become the vehicle of choice for the promoters of actively managed funds sooner rather than later, especially as we already have seen the launch of actively managed ETFs in several parts of the world.

Therefore, I predict that ETFs will replace mutual funds in the future, but only as distribution vehicle and not with regard to their management approach—passive versus active, as it is discussed by many market observers and participants nowadays.

The views expressed are the views of the author, not necessarily those of Lipper or Refinitiv.

Refinitiv Lipper delivers data on more than 330,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.

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