How regulatory changes could lead to a boom in new ETFs, including actively managed ETFs. Why ETFs continue to be one of the most innovative, cost-effective and tax-efficient investment vehicles.
“Exchange-traded products are among the most significant financial innovations in recent decades and have shaped financial markets as we know them today,” said Michael S. Piwowar, former Commissioner of the U.S. Securities and Exchange Commission.
The growth in exchange-traded products (ETPs) has been incredible over the past decade. There is $4 trillion invested in U.S. sponsored exchange-traded products (ETPs), spread across 2,435 different funds. That is up from $794 billion invested in ETPs in 2009. The overwhelming majority of those assets are invested in exchange-traded funds (ETFs) as there is only about $20 billion in exchange-traded-notes (ETNs).
Despite the growth in ETFs, mutual funds still have a commanding lead with 8,000 U.S. sponsored mutual funds managing over $15 trillion in assets. Yet mutual funds continue to lose market share to ETFs. So far in 2019, $135 billion has flowed into ETFs while mutual funds have experienced $200 billion in outflows.
ETFs have several advantages over mutual funds. Their expenses are lower, and they are more tax efficient. This is due to the unique process ETFs have for creating and redeeming new shares. Rather than handling the share creation and redemption process internally like mutual funds, ETFs work with outside institutional traders called authorized participants to create and redeem new shares.
In addition, most ETFs trades occur on stock exchanges rather than directly with the sponsor, which means the ETF sponsors incur lower costs related to shareholder services compared with mutual funds. This intraday trading also results in greater liquidity for ETFs relative to mutual funds, which only trade at the end of the day. For most long-term investors this ability to trade during the day isn’t particularly meaningful.
One concern with ETFs is that while they appear to be quite liquid, the ETFs’ underlying holdings might be illiquid during times of financial stress. For example, an ETF that invests in bank loans or high yield bonds might find authorized participants are unwilling to participate in the share redemption process if the authorized participants don’t believe they will easily be able to sell the holdings they are given in exchange for ETF shares.
Actively Managed, Non-transparent ETFs
Recently, the U.S. Security and Exchange Commission made two regulatory changes that will make it easier for mutual fund companies to compete with ETFs.
The SEC approved a framework that will allow for actively managed ETFs. Previously ETFs had to frequently disclose their holdings in order to facilitate share redemption and creation. Now the SEC will allow non-transparent ETFs. This is a special class of ETFs in which the sponsor doesn’t have to make its holding publicly available on a daily basis. Instead, the ETF sponsor will work with special representatives who get to see the holdings and promise not to disclose them. Those representatives in turn will work with authorized participants to facilitate ETF share redemption and creation.
Active managers don’t like to disclose their holdings on a daily basis as it can tip off competitors and traders as to what they are buying or selling, potentially making it more costly to enter or exit the underlying holdings.
Easier to Launch New ETFs
Another change is the SEC has made it easier for ETF sponsors to launch new ETFs. Previously, each ETF had to be closely vetted by the SEC before given permission to launch. Now ETF sponsors can follow certain rules and steps to launch an ETF without having to get direct approval by the SEC.
These two changes will more than likely lead to an increased supply of ETFs as sponsors will be able to launch new products at a lower cost and will have more flexibility to launch actively managed ETFs.
Of course, more ETF products doesn’t necessarily mean better investment options for individual investors. It could just mean more expensive ETFs that underperform passive indices in the same way that many actively managed mutual funds do.
To learn more about how changes in the ETF landscape can impact you as investor, please listen to this episode of the Money For the Rest of Us podcast.
Topics covered in the episode include:
- How big is the ETF market relative to mutual funds.
- What are the benefits of ETFs that have allowed them to gain market share from mutual funds.
- What are some of the negatives with ETFs.
- What has changed to make it easier for sponsors to launch new ETFs.
- How do non-transparent actively managed ETFs work.
- What are some examples of more complicated, outcome-based ETFs.
- [2:45] The benefits of ETFs
- [8:40] Challenges with ETFs
- [12:50] The rules that have changed
- [15:25] What is an AP Representative?
- [18:40] Should you invest in actively managed ETFs?
- [21:30] All about outcome Based ETFs
- [26:20] Understand what drives performance
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