State of play: consolidation and innovation drive US ETFs' record year

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Ben Johnson, Morningstar

To say 2021 has been a big year for ETFs is a bit of an understatement, writes Bailey McCann, reporting from New York for ETF Express. 

Total flows into the US ETF market have topped USD600 billion this year - beating prior yearly totals and with three months left to go, according to data from Bloomberg. Assets in the world’s largest ETF, SPY are also above USD400 billion for the first time - a new record.

If this pace continues, inflows to US ETFs could top USD1 trillion in a single calendar year for the first time. 

There are several factors driving record flows to US ETFs. M&A activity, as well as the entrance of mutual fund managers through fund conversions and new offerings, are poised to pull assets away from mutual funds and into ETFs. New strategies are also bringing investors into the space. Issuers are offering increasingly sophisticated strategies within the ETF wrapper attracting investors of all types who like the liquidity, ease of use and tax advantages. 

The US ETF market has long been dominated by three largely passive issuers - Vanguard, BlackRock, and State Street Global Advisors but this year has put pressure on the established order. 

Late last week, the Wall Street Journal reported that SSGA and Invesco were getting more serious about a possible merger deal that would make the combined entity the third-largest issuer in the US offering both active and passive funds. If it goes through the deal is indicative of a larger consolidation trend already underway in US ETFs. Invesco already has OppenheimerFund Inc. and Guggenheim Partners ETF businesses under its banner. 

Mutual fund managers are also entering the ETF market through multiple avenues. In August, USD2.6 trillion mutual fund manager Capital Group rolled out a slate of six ETFs - the first of what appears to be a growing lineup of new funds. The move was significant in part because of Capital Group's prior reticence to offer ETFs, but investor demand is hard to ignore. Other mutual fund managers including Dimensional Fund Advisors and Guinness Atkinson have opted to convert existing mutual fund strategies into ETFs - a move that's a bit trickier than simply starting a new fund but has the benefit of bringing existing assets into a newly launched ETF. 

"What we're seeing is that asset managers want to be able to offer a strategy through as many channels as possible from defined contribution accounts to individual accounts. ETFs allow you to do that," explains Ben Johnson, director of global ETF research for Morningstar. "So, I think we're going to see asset managers work through the best way to bring a strategy to market. Standing up a new ETF is the easiest way. Mutual fund conversions can be a second or third option, but it's important to remember that there are a lot of boxes to tick for that and investors will have to see a clear benefit if they're going to vote to support conversion."

Issuers are also getting more sophisticated in terms of the types of new funds they are bringing to market. Both thematic funds and semi-transparent equities ETFs have captured flows this year as investors begin to view ETFs as more than just passive index funds. Both thematics and semi-transparent funds give investors the opportunity to add specific types of exposure to a portfolio and include some measure of active management. Flows into active and thematic issuer ARK Invest over the past year alone show that investors are on board. 

"We're seeing these funds being used in a very active way, regardless of how actively managed the underlying index might be," says Johnson. "Being able to get in and out of ETFs easily allows investors to use thematics or active ETFs to take a more tactical approach if they want to add a specific exposure for a certain period of time or align their portfolio in a specific way. I think that's a trend that is going to continue."

Issuers aren't the only ones innovating and driving asset flows. Behind the scenes, market makers have improved their technology and that's supporting growth. Nowhere is that more obvious than in fixed income ETFs, which have seen significant inflows this year despite concerns over inflation. 

"We've seen the market making environment around ETFs really improve and strengthen over the past few years," says Adam Gould, managing director, head of equities at Tradeweb. "Previously not every investor was set up to trade bonds and now you can get that exposure without having to trade the underlying bonds and that's popular with everyone - institutions, hedge funds, retail investors."

Gargi Chaudhuri, managing director, head of iShares Investment Strategy Americas at BlackRock agrees. "ETFs have shown that they have liquidity, even when the underlying bond market is under pressure as we saw in 2020," she says. "So, we expect the flows to continue - investors are still going to have fixed income as a core part of the portfolio. We are seeing flows adjust as the market takes a view on issues like inflation or interest rates."

Going forward, the story of the US ETF market will be less about flows - which are likely to remain elevated - and more about how investors are using the funds. Growing product sophistication makes it easier for investors to use ETFs tactically, which could have significant implications for the success of issuers. 

"The size of the ETF market has reached a level where I think you're going to start seeing a lot more segmentation," explains Todd Rosenbluth, senior director of ETF and Mutual Fund Research at CFRA. "It's going to be incredibly difficult to take over the top three spots, but we have already seen some movement within the ten biggest issuers at the large end and at the smaller end, there are boutique firms that have had really big success with individual thematic funds if they hit on the right idea at the right time."

Thematic issuers like Global X and Roundhill Investments are indicative of this trend. Both firms have had successful launches of ETFs focused on themes from solar energy to the metaverse. But mega issuers like iShares have also been able to capitalise on the right idea at the right time. iShares U.S. Carbon Transition Readiness ETF pulled in over one billion on its April launch date which Chaudhuri chalks up to growing investor interest in sustainability. 

"We spend a lot of time listening to investors and researching trends," she says. "Through that work, we identify where the gaps are, and we can build a very bespoke product that is going to fill the gap. There are a lot of factors that investors are paying attention to within ETFs, they want to see the quality, trading volumes, if it is benchmarked well. There are a lot of options for ETF investors, so you have to invest the time and bring a product to market that provides value if you want it to be successful."

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