Measuring Innovation in the ETF Industry

24 Pages Posted: 17 Jun 2020

See all articles by Dan Weiskopf

Dan Weiskopf

Toroso- ETF Asset Management Firm

Date Written: May 4, 2020

Abstract

ETF Think Tank tracks ETF asset growth at about a 19% annualized rate due to two primary factors:

1. Client Alignment Growth Factors (Low Cost, Tax Efficiency, Transparency and Liquidity)
2. Innovation Growth Factors (Access, Alpha Generation and Active Implementation)

In this paper, we review which factors are likely to drive future ETF growth by evaluating how the growth-driving factors have evolved in the past decade.

For many investors, the client alignment growth factor of low cost is seen as the primary driver of ETF asset growth. However, in this paper, using December 31, 2019 year-end data, we look back at the Top 20 ETFs launched every year in the past decade, measured by current assets under management (AUM. We categorized them between Low Cost Solutions (LCS) and innovation growth factors. The data illuminates a clear trend that innovation growth factors, like access, alpha generation and actively managed, are now becoming key to the future success of the ETF industry. Most importantly, the data highlights a new key performance indicator (KPI) called the “Annual Client Alignment to Innovation (ACAI).” No, it is not a super fruit, but rather a measure of the 20 most successful ETFs launched each calendar year. ACAI compares the ratio of launches and AUM from client alignment factors, like low cost, to innovation factors like alpha generation.

In many ways, this is the essence of the meaning behind the utility value of the label Smart Beta, or, what we refer to in the ETF Think Tank, Non-Traditional ETFs. Developing the proper nomenclature to describe innovation in Non-Traditional or Smart Beta ETFs requires consistency of definitions. To that point, and for purposes of this study, we have used the acronym AAA: Access (first to provide), Alpha Generation and Active, as a catch all for ETFs that have succeeded through innovation. From an investor’s stand point, we think of the use of Smart Beta as a “smart bet on AAA”. These are the three elements that define the utility value for an ETF investor who cares to seek value through security selection rather than low-cost, broad market exposure. For purposes of measuring innovation, we argue that active vs. systematic rules are not different for the investor’s purposes, because the utility value is simply the access. The trend is clear - although liquidity and low-cost factors drove the first wave of ETF success from 1995 to 2009, innovation has been a greater driver of success for ETFs launched in the past decade.

Conclusion: ACAI Is Showing Positive Trends in Innovation. As measured by ACAI, the ETF industry is evolving and thriving with different types of investment solutions. AUM flows and popular mindshare might focus on price, but clearly, in the future, structure will matter in many of these solutions. The way that institutions and financial advisors use the ETF wrappers to reflect their fiduciary responsibilities in an overall portfolio will be essential to their ETF Strategy. Large institutions, like pension plans, endowments and/or insurance companies, may choose to build awareness of their ESG mission using the ETF wrapper. Family offices, whose beneficiaries are tax targets, could choose to launch ETFs with their own personal ESG message, that reflects the family values and helps to educate and involve their younger generations. The real question is whether or not hedge funds, with vast resources and marketing leverage, will choose to wrap part of their liquid alternatives in the transparent tax advantaged wrapper while trading other parts of their strategy. Innovation is just beginning!

While ACAI may skew towards survivor bias as flows in the Top 20 ETFs change AUM each year, the process of identifying and highlighting innovation in the ETF industry is important. Investing in ETFs may be about lowering investor cost and certain Client Alignment factors, but it is not the sole reason why ETFs have been successful. We can reasonably believe that overall investor costs will continue to go down. However, innovation is more than just cost reduction. This is evidenced by the ACAI ratios in terms of both AUM and percentage of ETFs offering innovative solutions in the Top 20. These are steadily increasing – at a respective 25% and 15% in 2009, both are now over 95%. While numbers in the 90th percentile may be skewed by the shortness of 1 year in 2019, we note that the 3-year, 5-year and 7-year numbers are consistent; AUM is between 75% and 77% and numbers making the Top 20 are between 64% and 69%. With that in mind, we believe the evidence shows that investors in this new market will demand innovation as a core part of the ETF solutions in new launches.

Using the ETF wrapper to identify a SMART BET on active, access or alpha is the future of investing since investors want liquidity, tax efficiency and low cost. Over the past decade, flows into homogeneous low-cost ETFs have dominated the headlines, but if we know anything, it is that past performance should not be indicative of future outcomes. Investment markets and opportunities have evolved.

Suggested Citation

Weiskopf, Dan, Measuring Innovation in the ETF Industry (May 4, 2020). Available at SSRN: https://ssrn.com/abstract=3592387

Dan Weiskopf (Contact Author)

Toroso- ETF Asset Management Firm ( email )

United States

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