What Does 2017 Hold for ETFs? 3 Trends for Investors to Watch

Image source: Getty Images.

Exchange-traded funds (ETFs), mutual funds that investors can trade like stocks, have taken the investment management industry by storm over the past decade thanks to their combination of low cost (ETFs were fist conceived as index funds) and convenience. What does 2017 hold for ETFs? Here are three trends that build on last year's momentum.

The ETF sector will continue to grow faster than the fund management industry

In the 11 months leading up to Nov. 30, 2016, aggregate ETF assets rose at a healthy annual clip to reach nearly two-and-a-half trillion dollars in November:

Data source: Investment Company Institute.

That performance far outpaced mutual funds:

Data source: Investment Company Institute.

Per Thomson Reuters Lipper, U.S.-based actively managed stock funds suffered a whopping $288 billion in outflows in the year through Nov. 30 -- the largest such amount on record. I have every reason to believe the trend of assets migrating from actively managed funds to index funds -- whether traditional index mutual funds or index ETFs -- will continue in 2017. Two statistics are enough to explain why:

• Per investment bank Jefferies, only a third (33%) of active fund managers beat their benchmarks last year.
• If we drill down to the largest category, Bank of America found that fewer than one in five (19%) active fund managers in the large-capitalization segment beat the Russell 1000 Index, with just 18% beating the S&P 500 Index.

That latest statistic also explains why I believe the largest ETFs are likely to continue to grow faster than the ETF sector in 2017:

The "elephants" of the ETF sector are well positioned to continue to growing faster than the sector itself

Three ETFs (see table below) -- out of 1,694 -- represented more than half of the aggregate increase in ETF assets under management.

Data source: State Street Global Advisors, Vanguard. YOY = year over year.

The business of index fund management is a high fixed-cost/low variable-cost model. There is an upfront investment in infrastructure and personnel (even index funds need a few people to administer them) that is significant; once that investment is made, the costs associated with managing additional assets is very low.

Index fund investors are highly price-sensitive, and with the advent of ETFs, the ease with which one can switch from one index provider to another forces fund houses to compete almost exclusively on price. New entrants have a very difficult time competing with index "elephants" because they lack the assets over which to spread their fixed costs; the low-cost provider -- the elephant -- wins.

(Vanguard, which is mutually owned -- i.e., owned by its fund investors -- has an additional advantage when it comes competing on cost.)

For this reason, I think the elephants of the ETF industry, Blackrock Inc.'s iShares, State Street Corp's State Street Global Advisors, and Vanguard, will grow faster than the sector in 2017. Whether that transpires or not, one thing is beyond doubt: These three companies will continue to dominate the sector.

Smart beta ETFs will grow faster than the ETF sector

Where index funds provide exposure to "the market," or beta exposure, so-called "smart beta" ETFs enable investors to drill down and gain exposure to specific factors (e.g., value, growth, momentum, etc.).

In its third annual survey of smart beta published last year, index provider FTSE Russell called 2016 "a turning point in smart beta evaluation," noting that the percentage of institutions then considering smart beta had doubled since 2014. As such, I believe the smart beta category is poised to grow faster than the sector as a whole in 2017. And the companies that are best positioned to take advantage of this growth? You guessed it: The same three "majors" I mentioned just a few paragraphs above. Indeed, those three companies offer 13 of the 14 largest smart beta ETFs by assets, per a screener on etf.com.

Many of the "innovative" new products ETF providers tout in their marketing materials are nothing more than Rube Goldberg financial products designed to enrich the ETF provider rather than investors. As such, they represent a regression, not innovation. However, smart beta represents a legitimate advance, even if they require investors to possess some degree of financial literacy to achieve the benefits.

Indexing in a richly priced market

Exchange-traded funds represent a genuine innovation from and improvement to the fund management industry. Active fund managers have been overcharging their investors for mediocre performance for too long, and by and large, index ETFs represent a superior alternative. However, it is of some concern that the wave of assets washing into these ETFs has turned into a tsunami at a time when the broad market looks richly priced. While I continue to think dollar-cost averaging into low-cost index funds is the optimal strategy for individual investors, it's not absurd to think that a leaner actively managed fund industry will get the opportunity to shine again -- and perhaps sooner than expected!