At the Janus Henderson Global Media Conference, “New Investment Paradigm: Uncovering Opportunities and Challenges,” our senior leaders and key portfolio managers from around the globe shared their insights and outlooks for their markets. In this session, Nick Cherney, Head of Exchange Traded Products, explains why he believes active exchange-traded funds (ETFs) could triple in value over the next four years to $1 trillion.
Louise Beale: Let’s move on to what is next in our running order and it’s time to check if it’s time to get active in ETFs, and for that I’m pleased to introduce Nick Cherney, Head of Exchange Traded Products here at Janus Henderson. Nick, I’ll pass over to you.
Nick Cherney: Great. Thanks, Louise. Appreciate the introduction and thanks, everybody, for joining us today. I’m here to make a relatively simple but I guess bold prediction, which is that active ETFs are going to reach a trillion dollars in assets globally by 2025. That’s actually a benchmark that the global ETF industry itself reached over a decade ago, which coincidentally is also when active ETFs were first introduced. Reaching that one trillion mark is going to require the active ETF market to triple over the next four years.
I believe there’s three major drivers that will cause that to happen. The first of those and probably the most important is investor demand and then the resultant supply response, and that’s where I will spend most of our time today. Two other significant factors in the U.S. market are the evolution of the market structure and the changing regulatory landscape. Sorry, I think we’ve got our slides backwards. If we could skip one slide, that would be helpful. Thank you.
The active ETF industry today has over 1,000 products listed in 13 different countries. Like the rest of the ETF industry, of course the U.S. is dominant, with about 60% of the total assets. A little surprisingly, China is second. There’s then another 11 countries rounding out the last 20% of global assets. So while it’s still only a small part of the global funds industry and just about 5% of global ETF assets, last year was record-breaking for actively managed ETFs. They drew in $8 billion in new inflows in their largest market, which as I mentioned is the U.S.
But what is it that’s driving the demand for active ETFs? If we could flip back to that prior slide? It’s been clear, first of all, for about a decade that U.S. investors have been moving their money from mutual funds to ETFs and net flows to ETFs have exceeded those into mutual funds for each of the last six years. Now, 30 years ago when ETFs were first introduced, they were synonymous with passive investing and many of the early adopters weren’t just choosing ETFs, but they were abandoning active management.
If we fast-forward to today, around one-fourth of U.S. equity trading volume is in ETFs and that can’t really be due to passive investors building market cap weighted portfolios and quarterly rebalancing them. Clearly passive investing simply can’t be generating that kind of trading volume.
What’s happened instead of course is that ETFs have become a tool of choice for active managers themselves, whether that’s individual investors, large global institutions who are seeking the most efficient means to implement their active portfolio construction, or really a whole range of other users. So while the asset management industry itself has come to the idea that an ETF is synonymous with passive, the investing public severed that link really a long time ago.
Today, meme stocks, cryptocurrencies seem to rule the financial headlines and these stories fly directly in the face of a narrative that investors don’t believe in active management anymore. No one is out there building market cap weighted portfolios of game stock or bitcoin, but underlying these stories is something maybe a little more interesting, which is really a broad-based resurgence of interest in active investing and trading that’s disintermediated and available immediately.
The last 20 years of technological change have led consumers to expect infinite variety. They want instant availability and they want it at extremely low cost. In the world of investing, ETFs provide that choice and have really come to represent for many investors, particularly younger investors, not a question of active versus passive, but of modernity versus an archaic financial system. The reality obviously is a lot more complex.
We firmly believe that each fund structure has its valid purpose and really good evidence of that is that 88% of U.S. households that own ETFs also own traditional mutual funds, but the cultural shift that’s occurring among the investing public seems relatively undeniable at this point. So my thesis is that ETF popularity will continue to increase not only because of the structural benefit to the product in terms of trading, transparency, tax efficiency, low cost, but also because there’s a larger cultural zeitgeist, which is simply to view ETFs as the modern improvement on the traditional open-ended fund.
Uber’s probably a fairly relevant analogy here. It’s modern, it’s efficient, it’s easy to use, it’s often cheaper and, frankly, most consumers simply prefer to take an Uber versus a taxicab. ETFs probably won’t do to mutual funds what Uber has done to taxicabs, but the trend is the same and the consumer preference dynamics are similar. This means that many of the investors who own the nearly $100 trillion in actively managed assets globally today would prefer to gain that exposure in an ETF. In fact, a recent survey showed that 51% of U.S. ETF investors said they would buy an active ETF this year.
This incredible demand must also be met with supply and asset managers are responding. So last year alone saw 31 new managers launch active ETFs in the U.S. and we expect this base to continue. One area in particular where active ETFs are likely to see significant focus is in ESG products. ESG is really a process that requires the discretion and analysis that isn’t well suited to indexes that rely on fairly crude screening methodologies. So this evolution in the preference of consumers for ETFs and the more recent acceptance of this fact by active managers will be the primary mechanism to get us to one trillion in active ETF assets by 2025.
But in response to that reality there are two additional factors that are going to accelerate growth and I want to touch on them briefly, and that’s market structure and regulation, particularly in the U.S. So decades ago Schwab revolutionized mutual fund distribution with the introduction of its zero-transaction-feed mutual fund platform. But for a long time since then an impediment to ETF growth has been the revenue model of most of the largest wealth managers who have historically relied on mutual fund fees for a significant part of their revenues.
Today of course nearly every major brokerage firm has made trading of ETFs commission-free. In addition, most of the largest wealth management platforms are rapidly adjusting their revenue models, moving significantly to fee-only advisory and model delivery, things which continue to favor ETFs. So this structural change in the wealth management industry is not particularly visible to most investors, but it has the possibility to be a major driver of growth for active ETFs.
Finally, even the regulators in the world’s largest market have caught on. While active ETFs have been available in the U.S. for over a decade, not until 2019 did the SEC finally overhaul its rules governing the issuance and listing of exchange traded products, effectively eliminating the regulatory distinction between active and passively managed products. The impact of this rule change is that a much broader swathe of active managers are likely to now see the ETF wrapper as a viable mechanism for them to deliver investment management services to their clients, which should further fuel growth.
In fact, the process of converting active mutual funds to ETFs has begun already with $30 billion converted just this year. So when we consider the incredible growth in investor demand for actively managed ETFs, the response that is triggered in terms of supply, the changes in wealth management revenue models, and the evolution of regulation, it seems to me that a trillion dollars is probably just a small milestone on a much more significant transformation unfolding in the global financial landscape. Louise, thanks for hosting us. Do we have any questions that have come in?
Beale: Yes. Hi, Nick. Yes, we do actually have some questions for you. The first thing, you mentioned converting the existing mutual funds into ETFs. Is this a trend you expect to accelerate in the years ahead?
Cherney: Yes. We’re very early days. We’ve only had a small number of conversions but, as I mentioned, it’s more than $30 billion in total assets so far this year. So this has been something that’s been talked about for a long time but, frankly, the regulatory infrastructure just simply hadn’t caught up. What’s going on today, some of these factors that I just talked about, particularly around demand, and then when you layer on top of that the tax benefit of the ETF structure, I think we’re going to see a significant acceleration in those conversions. I think really the primary path in growth, if we look back maybe a decade from now, is not going to be necessarily new ETF launches, but rather the conversion of a significant portion of existing mutual fund assets.
Beale: Okay, thank you. Another question coming in saying, how important is transparency to ETF investors?
Cherney: Synonymous, it’s been synonymous for 30 years, transparency, and then there’s been probably ten or 12 years of work going on to try to introduce non-transparent active ETFs. So products that enable active managers, such as many of the folks that you’ve talked to today, to continue to manage their portfolios without disclosing those holdings to investors. Starting a decade ago, really in the fixed income markets, many active managers began getting comfort with the daily disclosure that’s required and so I think what’s happened is that transparency is probably overrated in the sense of investor concern around it in daily transparency, but it’s maybe also overrated in terms of the need to maintain it.
So I think what’s happened is more and more active managers have seen the successful launch of transparent active products, realized that they’ve been able to continue to deliver alpha in a transparent manner and so I think that we’re going to see a convergence of those things. So far, the non-transparent structure really hasn’t picked up steam. Janus Henderson ourselves launched just yesterday our first actively managed equity ETF in the U.S. and I think we’re going to see that continuing.
Beale: Actually, that leads onto our next question which is that the active non-transparent structure has been approved for about a year now. Has asset growth meet expectations?
Cherney: It depends whose expectations. It’s met my expectations which is for very, very limited growth. Really what we’ve seen so far is a lot of interested parties, so affiliated fund managers, sponsors of these structures, etc., who have allocated capital to these non-transparent products. But we haven’t seen a major distributor onboard them and we’ve really seen very anemic client demand. Our view on it is that what our clients want is to get after tax, after fees, risk adjusted alpha, it’s as simple as that. If we can deliver that in a transparent structure, we will. If it turns out that the non-transparent structure is the vehicle of choice for our clients and is a better way for us to deliver on that client promise, we’ll go there. But so far, we just simply haven’t seen the client interest.
Beale: Okay. One final question we’ve got time for. It’s coming in saying, are there types of active strategies that aren’t a good fit for the ETF structure?
Cherney: No. Yes, there certainly are around transparency and so I think there’s some misnomers out there around some of this. So people sometimes get caught up in the liquidity of the underlying assets. I think that’s a little bit of a red herring in the sense that the ETF structure is actually quite robust, and it works quite well with both liquid and slightly less liquid underlines. The one area where I think active managers will probably resist, for good reason, rolling out actively managed products is in products where that transparency can really hurt their alpha.
So that is very particular to the portfolio manager or the strategy that they’re deploying and whether or not disclosure of those positions on a daily basis is likely to undermine their ability to generate returns. So I don’t think the ETF structure is appropriate everywhere, but I do really believe that there’s a shift, a continuing shift. A trillion dollars sounds like a bold prediction, but I think we’re going to pass it pretty quickly and blow through it over the next five to ten years.
Beale: Okay. Nick Cherney, we’re going to have to leave it there, but thank you very much for that. It’s a really fascinating whistle-stop tour through all of that, so thank you very much indeed.
Investment Company Institute, “Investment Company Factbook,” 60th edition, 2020.
RIA Biz, “Dimensional Fund Advisors rocks the mutual fund industry by undertaking mass conversion of its mutual funds to ETFs,” July 2021.
The Cerulli Edge, “U.S. Monthly Product Trends,” Issue #121, January 2021.