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Over the past 20 years, exchange-traded funds have revolutionized the investing world. As a middle-ground between individual stocks and mutual funds, ETFs bridged a key gap in giving investors flexibility in trading diversified portfolios of assets on their own schedules.
Recently, though, a couple of trends have surfaced that could change the ETF industry -- and not necessarily for the better. Let's take a look at these threats to your wealth and what you need to watch for as the ETF industry seeks new avenues for growth.
The haves and the have-nots
ETFs have become a staple of the investment world, and as you'd expect from any successful new investment vehicle, financial companies have tripped over themselves trying to provide ETF solutions to cash in on demand. Going from just a handful of ETFs in the 1990s, the ETF universe now sports almost 1,500 different funds with just about every combination of asset and subasset class you could ever want to see.
But some signs have arisen that the growth in traditional ETFs may be reaching its limit. A look from Citigroup at the ETF industry found that the vast array of available ETFs has made it increasingly difficult for new funds to distinguish themselves from the crowd. If it persists, that trend will have two big impacts: Small players in the ETF market will find it difficult to get enough assets to become economically viable, and even the larger ETF companies will struggle to come up with new fund ideas to gather new assets. In other words, the current state of affairs will have ETF giants BlackRock (NYSE: BLK ) , State Street (NYSE: STT ) , and Vanguard fighting it out to retain their collectively dominant market share, leaving smaller players to defend and make the most of their existing niches.
Where will growth come from?
Just because the battle lines are drawn more definitely doesn't mean that the industry can't keep seeking more assets. In particular, trillions of dollars in retirement account assets are an obvious target for index-tracking ETFs.
The catalyst for a shift could well result from the coming disclosure of fees on 401(k) plans. As investors discover how much more they have to pay on the actively managed mutual funds that many plans use as their only investment options, companies will feel pressure to turn to lower-cost alternatives that better preserve their workers' retirement savings. The flood of money into ETFs could in turn revitalize the largest ETF providers, gaining even more massive economies of scale and potentially creating a positive feedback loop that would allow them to reduce fees even further.
Meanwhile, another key driver for growth in the ETF universe will come from how regulators handle the explosion of interest in actively managed ETFs. Based on the experience of Pimco's ETF version of its Total Return Fund, investors are hungry for active ETFs.
Thus far, though, getting approval of actively managed ETFs has been a tough road for managers to follow. As mutual-fund companies Legg Mason (NYSE: LM ) and T. Rowe Price (Nasdaq: TROW ) have tried to respond to attacks from index ETFs by creating active ETFs of their own, the SEC has taken extremely long times evaluating and performance due diligence on the fund applications.
Analysts at Goldman Sachs have a positive view of future ETF growth, expecting it to hit the $2 trillion mark in assets within the next three years. But it sees active-ETF status as potentially being an asset worthy of takeover bids. In particular, Goldman names small player WisdomTree (Nasdaq: WETF ) as a promising target, with its mix of innovative index-based funds combined with a growing stable of active ETFs.
For investors, competition among ETF giants makes their shares look less attractive than their past growth may suggest. But if consolidation in the industry starts taking place, smaller players like WisdomTree could make very good investments.
In the meantime, investors should applaud the trend away from further growth in the number of ETF offerings. The sheer mass of ETFs intimidates many investors, leading them away from their most prudent choices. At this point, keeping the index ETF universe at its current size while gradually adding active ETFs could be the happy medium for investors.
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