The ability of ETFs to adapt quickly has been key to their ongoing success
Resilience
Demand for ETFs has soared recently, largely due to the sector’s resilience—its ability to adapt quickly to a rapidly-changing environment, regardless of the market environment. Some recent ETF innovations include:
Actively-managed funds
ETFs generally began life as passive funds that track an underlying index—highly liquid investments that offer more favourable cost structures than mutual funds. However, the accompanying return is limited to that of the index and, as investors became more comfortable with the ETF product, they started looking for above-index returns. Actively-managed funds served as the logical solution.
Semi-transparent structures
Transparency is a key characteristic of ETFs. However, this attribute has a drawback within the active space. In markets such as the US, ETF managers are required to disclose their underlying securities daily. Not surprisingly, active managers have been reluctant to enter the ETF space based on the requirement to disclose their “secret sauce”—the custom technique that is delivering above-index returns. In response, the ETF industry has developed semi-transparent fund structures where the manager discloses details of the portfolio less frequently—or via a proxy basket or intermediary. This helps to protect the managers’ intellectual capital.
Mutual fund conversions
The recent growth of ETF investment flows has caught the attention of mutual fund managers, particularly active managers in the US. Supported by the advent of semi-transparent ETFs, managers have recently begun to consider mutual fund conversions to ETFs, providing the opportunity to attract additional investors while leveraging their existing asset base and track record. There is a similar trend in the Canadian market where active ETFs are already the largest number by ETF type1—at least partially due to the country’s innovative approach to ETF disclosure requirements. Canadian niche managers are also looking to leverage their existing assets and performance record to create active ETFs.
ETF series
The addition of an ETF series to an existing or new mutual fund trust has recently seen growing interest from mutual fund issuers looking to broaden distribution into the ETF space. This fund structure enjoys the benefits of scale due to the management of multiple series in a single fund and lower fixed costs by not having to maintain separate mutual funds and ETFs. However, the ETF series is generally subject to additional spread costs and may not provide the same transparency as standalone ETFs.
Thematic investing
ETFs are also immersing themselves in the thematic space—a key growth area as the younger demographic looks to invest in “trends” rather than specific companies. These themes encompass sectors such as ESG (environmental, social and governance), technology, artificial intelligence, electric vehicles, healthcare and robotics.
ESG investing
Europe is leading the way in embracing ESG investing. ESG ETFs in Europe recorded $54 billion in inflows during 2022, accounting for 65% of all fund flows to the European ETF market, according to Morningstar.2
Digital assets
The digital asset space is also becoming more attractive for ETFs. Canadian regulators allow direct ownership of underlying cryptocurrency and, in early 2024, the US Securities and Exchange Commission approved the first US-listed ETF to track bitcoin.3 Crypto is likely to play an increasingly important role in multi-asset strategy ETFs going forward.