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June 14th, 2012 by

ETF Growth: Will It Hit A Wall By Brendan Conway

Bernstein Research poses the question this morning. Yes, the firm argues, exchange-traded funds’ growth could slow considerably. It could happen without a break into 401(k) plans and without substantial new growth outside ETFs’ home base in passive investing.

Bernstein’s Luke Montgomery, Brad Hintz and Gabriel Farajollah are specifically challenging the view that active management and fixed income can drive the industry’s asset levels as high as hoped. They’re taking on the view that the ETF industry will grow from the current $1.2 trillion in assets to $2 trillion by next year and $10 trillion by 2020, instead projecting $6 trillion by 2025. This 13% compound annual growth rate that could be upped to 17% if ETFs can break into the defined contribution market, they write, but they’re calling the most promising new growth areas “also the most tenuous.”

401(k)s and defined contributions: ETFs have fewer natural advantages to mutual funds in this niche and must contend with technical challenges, the trio of analysts note. Not to mention a “lack of motivation” among incumbent plan providers. They note that mutual funds have 27% of AUM in the defined-contribution business; ETFs have less than 1%.

Active management: Actively managed portfolios are often viewed as the big growth area for ETFs. But the idea suffers from “ambiguous value propositions,” the analysts write: “The industry has so far insufficiently addressed questions about why investors really need actively-managed ETFs … The main challenge with active ETFs had been the need to maintain holdings transparency—which is necessary to prevent NAV discounts and premiums—without exposing the funds to front running.”

Fixed income: Cautious here, too: “Bond ETFs suffer from the dubious value proposition that characterizes many times of bond indexing. Namely, investors are less enthusiastic about fixed income indexing, which can lead to a problem of adverse selection of debt securities (companies and governments with the largest index weightings are typically those with the most debt outstanding).”

One of the more interesting suggestions in the piece is that the industry may have gotten most of the mileage it’s going to get by supplanting mutual funds, big swaths of which it hasn’t actually supplanted. Passive index-based mutual funds clearly have suffered. But that’s less true elsewhere:

A mistaken belief is that every dollar of ETF AUM is won at the expense of active mutual funds. Evidence suggests ETFs have curbed growth of index mutual funds, which has flat-lined since the advent of ETFs. Moreover, ETFs appear to be creating incremental demand for packaged products. Recent ETF demand has emanated largely from institutional investors, who are cyclically underweight active management. Also, ETFs now represent one-third of equity exchange volume, offering solid evidence they are supplanting retail trading in single stocks. From this perspective ETFs have expanded the “fund” industry—but the spoils of this growth accrue unevenly.
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