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ETFs in Asset Allocation (Part 1)

ETFs in Asset Allocation (Part 1)

Prerna Chandak, MBA

Vice President ETFs

ETFs are the fastest-growing segment of the asset management industry and this momentum shows no sign of dissipating moving forward.

The global ETF industry ended 2019 with $6.1 trillion (USD) in assets, representing a 20 per cent compounded annual growth rate (CAGR) over the decade. The number of ETFs available increased from 1,967 at the end of 2009 to close to 7,000 globally by December 2019. In the past few decades, ETFs have done relatively well during periods of volatility as investors rotate out of strategies to migrate to ETF solutions.

At the end of January 2020, global ETF assets were at a record high of $6.37 trillion (USD) with January recording the second highest flows on record ($67.2 billion USD). Investors are clearly showing increasing confidence in the ETF structure.[1]

ETFs have fundamentally changed the way people invest given their transparency, efficiency and versatility.  Exchange trading also offers intra-day liquidity and an externalization of costs, where every investor bares the cost of their entry and exit from an ETF. Institutions, advisors and individuals are all using ETFs to meet various investment needs. ETFs are used as portfolio management tools in very active ways to achieve certain geographic or sector tilts, for diversification, to gain exposure to one or more investment factors and to reach inaccessible markets and strategies such as liquid alternatives.                                          

As we commemorate the first 30 years of the global ETF industry, let’s review some key drivers that will propel the industry forward over the next 30 years.

ETFs in Asset Allocation

The growing importance of asset allocation will ensure that active management will continue to be delivered and monetized differently. Some of the industry’s growth will come from substituting ETFs for other investment vehicles such as individual securities as more investors become asset allocators and place importance on manager selection, sector or geographic allocation and cost. The migration from individual securities to ETFs will arise from a number of scenarios, including investors moving away from direct replication of an index to reduce trading costs and higher correlations amongst companies in certain sectors. Alpha generation from individual security selection will still be found in market segments where investors can take advantage of informational inefficiencies.

Investors will also turn to ETFs for more objective driven solutions.  For example, wealth preservation, risk-managed growth or income drawdown. As a result, more retail and institutional investors will make larger allocations to ETFs. The ETF user base is expected to grow, and ETFs will make up a larger portion of investors’ portfolios. To meet their needs, asset managers will provide a suite of product offerings including index, strategic beta and active ETFs ranging from more vanilla strategies to Environmental, Social, Governance (ESG) and liquid alternative solutions.

ETFs will also compete against other investment vehicles used by institutional investors such as index futures and swaps where cost and operational efficiency make ETFs a compelling option. For example, the divergence between the cost of index ETFs and the cost of access to bank balance sheets is growing, making the decision easier for institutional investors to switch to using ETFs for the same purpose.

[1] Data sourced from Bloomberg, ETFGI as of February 24, 2020

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