• Future Focused: How Active Management has become the Third Leg of ETF Growth and Innovation.
Frank [00:00:02] Hi, I'm Frank Koudelka, Global Head of ETF Solutions at State Street. I am joined by Ciarán Fitzpatrick, Head of ETF Solutions in Europe and co-author of our recently published research titledFuture Focused: Insights into Global ETF Trends. We're conducting a series of podcasts with subject matter experts to take a deeper dive into the ETF megatrends we've been experiencing over the last several years. For this segment, we're joined by Jeff Sardinha, North America Head of ETF Solutions, and Ahmed Ibrahim, Head of ETF Servicing in Australia. Actively-managed ETFs have become a significant disruptor to the traditional passive ETF landscape. In our recent Future Focused paper, we discussed what has led to this market that had less than $50 billion in global assets only five years ago, to now enjoying close to a half a trillion in assets today, an annualized growth rate of close to 60%. We brought experts from the two hottest markets, North America and Asia-Pacific, to discuss the trends and expectations for the future. We'll also talk about Europe and why that market has had less of an appetite for active ETFs and what may change the thinking there. So let's dive in, Jeff, what are some of the key themes you're seeing in the Canadian ETF market, particularly regarding active management?
Jeff [00:01:24] Hey, Frank, thanks for having me. So interestingly enough, you started with Canada, the country with the largest percentage of ETF assets attributed to active management. Active ETFs account for about 23% of the overall market share in Canada and 30% of the flows, which is an uptick compared with 22% of the flows last year. So Canada has a key point of differentiation from other markets and also received a tailwind from the regulators several years ago. Unlike most other regions, Canadian regulators never required daily holdings disclosure normally associated with ETFs. So in other words, Canada did not differentiate its mutual funds and the ETF marketplace. Both are governed under the same rules set for portfolio disclosures. The big advantage of this limited portfolio transparency is that it gives managers greater confidentiality and ability to protect their trading strategies. In practice, actual portfolio disclosure does exist, but it differs between ETF managers and types of ETFs. The majority of actively managed ETFs provide varying levels of portfolio transparency to only their APs or dealers on a confidential basis and solely for the purpose of their market-making activities. Daily disclosure is not required, but as a best practice for a subset of strategies, there are varying degrees of that disclosure. Another benefit in Canada are the various choices available to enter the ETF space, including as a series or a share class of an existing mutual fund. A standalone ETF is the other main option. The series or share class allows issuers to leverage the scale and track record they already have, as well as speed and cost effectiveness of coming to market. So essentially the series of share class is affixing an ETF to an existing product. I mentioned the regulatory tailwind earlier and for active ETFs that was really the adoption of CRM2 or client relationship model 2. It was implemented in 2016. CRM2 requires advisors to provide investors reporting on fees and performance. The data shows that since its implementation, flows to ETFs have been slightly higher than mutual funds, even though it's from a smaller base of assets. And the number of ETF issuers in Canada have increased from 9 before 2016 to 42 today.
Frank [00:03:53] Thanks, Jeff, Canada is seeing unbelievable growth in the ETF markets but let's pivot to the US. Like Canada, the area we're seeing the most growth from new entrants is for actively-managed ETFs. What's driving the acceleration of active ETFs in the US marketplace?
Jeff [00:04:09] So last year, even during the pandemic, the industry saw record levels of launches with 477. 65% of those you would put in the active ETF bucket. But I don't know that that tells the whole story. If I dig a layer deeper and combine active with thematic/ESG or just non-market cap weighted products, it's actually closer to 95%. So this year has been slightly slower, about 132 products through April, but still, 84% of those launches fit into that same non-market cap weighted category. We're seeing actively-managed launches from all corners of the industry. Existing issuers expanding their suite of products to active management, eagerly anticipated new entrants like Capital Group, Neuberger Berman, Putnam and T. Rowe Price launching for the first time. And then we have firms like Alliance Bernstein and Morgan Stanley that have signaled the launch via regulatory filings. The story is no different really with flows, albeit at a smaller scale. From 2016 to 2021, active ETF assets sky-rocketed from $30 billion to $300 billion. They literally added a zero. Last year alone flows into active ETFs were 11% of overall flows, and that's compared to only 4% of overall assets. So hitting it almost three times its weight. And this year, active flows account for over 17% of all inflows to date. Now let's look at the why. So the US regulators began removing barriers to growth over the last 5 to 6 years. This includes the removal of restrictions on derivatives and international equity exposure, as well as the expansion of generic listing standards to active ETFs. More recently, the FCC adopted Rule 6c-11, the ETF Rule. 6c-11 democratized the ability to launch ETFs by reducing the time and expense to launch. The rule also enabled increased portfolio flexibility via custom baskets to maximize tax efficiency. Additionally, in 2020, semi-transparent actively-managed ETFs were approved, enabling managers to protect their trading strategy by eliminating that same daily holding disclosure requirement that we discussed in Canada. Lastly, I'd say the approval of the mutual funds to ETF conversion has allowed issuers to bring a lower cost ETF structure to market at scale with historical performance and track record.
Frank [00:06:38] Thanks, Jeff. Yes, the growth in the US has been incredible, in fact. Looking at the data, 33 of the top 50 asset managers in the US now have actively managed ETFs. 28 have their own line-up of ETFs and five as sub-advisors for other active ETF issuers. So the growth has just been incredible.
Ciarán [00:06:57] So I don't think we can deny that North America has certainly seen some significant growth and will continue to do so. I'd like to turn to Ahmed and look at innovations we've seen at the Australian ETF market. So Ahmed, you've been at the forefront of the innovations in the Australia ETF market. Can you tell us about the various options active managers have in Australia and how the innovation have led to growth?
Ahmed [00:07:20] Hi Ciaran, yes, the market has multiple options for active managers and we've seen an evolution in the ETF product offerings in the last 2 to 3 years. While passive ETFs continue to lead in both assets and flows, most of the new entrants are active managers who are adopting either the dual access or the ETF share class models to expand into the listed investor channel. It might be helpful for me to explain each of the models. The dual access model enables investors to purchase the strategy as a traditional unlisted managed fund through the transfer agency or as a listed fund through a broker. A key feature of the dual access model is investors can easily transfer units from listed to unlisted and vice versa. ETF share class model is similar, but has a key distinction, where an insurer opens a new share class of an existing managed fund structure as an ETF. Unlike the dual access model, shares can only be bought and sold on the exchange to a broker. In summary, the benefits to these options include: the ability to open up unlisted strategies to listed investors, broaden distribution channel penetration, lower costs by merging dual funds into a single product, and quicker time to market by leveraging existing fund instead of opening up a new fund.
Ciarán [00:08:39] Thanks, Ahmed that's very insightful. So the North American ETF markets offer active managers what is known as semi-transparent models, as it relates to portfolio disclosure. So looking at Australia again, does Australia offer the semi-transparent option for active managers concerned with front-running of its portfolios?
Ahmed [00:08:56] Yes, they do, Ciaran, the issuer or can choose between daily disclosure or quarterly disclosure with a lag for the dual access and ETF share class models. From our experience to date, the majority of issuers tend to adopt semi-transparent disclosure to protect their intellectual property. The semi-transparent products require an iNAV agent to generate and publish the indicative NAV intraday. Issuers need to monitor the integrity of the iNAV that is being published. They do this by generating and comparing its own iNAV at certain points throughout the day, or alternatively hiring a secondary iNAV agent to perform this function for them. Final consideration is internal versus external market making. Internal market making is often referred to as the Agency model and is typically adopted by issuers with semi-transparent ETFs. Here, the issuer would take on the responsibility of being the market maker, with any gain/loss from creations intentions being borne by the fund. We generally see issuers engaging the services of market maker to correlate orders throughout the day and send an end of day order file to custodian for processing. External market making often referred to as the Principal model, is where the market maker takes on the role of providing liquidity to the market. Another key requirement of the external market making model is to produce two basket/holding files. The basket file that goes to the iNAV agent would typically contain the full holdings of the fund, and the basket that goes to the market maker would contain partial holdings of the fund, with the remaining holdings being made up of a proxy. This proxy basket is also published on the client's website for the public to have access to.
Frank [00:10:41] Thanks on that, Ciaran, I'd like to turn the discussion to Europe. Although we're seeing incredible ETF growth overall in the region, active ETFs have lagged and they've not gained much traction outside of a handful of firms. What is the case here and what are the potential changes that can jumpstart the active ETF growth in the continental Europe?
Ciarán [00:11:03] Yes thanks, Frank, interesting question and we certainly are seeing continuous growth in the European ETF market. As noted, active ETFs only represent about 1% of the overall European ETF market. So depending on the reporting you read today, there are a number of different classifications as to what represents an active ETF, such as some reporting will include smart data and thematic product but I think the recent IOSCO paper from May 2022 captures the active ETF accurately. So if you read the report, it refers to the investment manager of an active ETF exercising discretion over the make-up of the portfolio in an attempt to outperform a specified index. So a key differentiator of an active ETF is the ability of the investment manager to adjust the portfolio intraday or at their own discretion without being subject to a set of rules of an index. With that IOSCO definition taken into account the true active ETF market in Europe is somewhere in the region of $20 billion as of April 2022. So this year we are seeing a growing interest from asset managers seeking to enter the European ETF market by launching true active ETFs. These are managers with a rich history and successful mutual funds and are planning a similar strategy to the mutual funds as ETFs. The European Active ETF market is currently on a fully transparent basis, so with daily portfolio holdings required to be published on a daily basis due to European regulatory requirements. So that differs to what was outlined by Ahmed and Jeff previously in their locations. The subject to semi transparency has also become a hot topic again with IOSCO having included transparency requirements across Europe in a recent consultation paper that I previously referenced. The portfolio disclosure, transparency and an effective arbitrage mechanism are all separate measures that IOSCO have included in the consultation paper. So we really do hope that this leads to a change in the requirements for ETF disclosure across the European market. But as Jeff mentions, the Canadian market is a great example where mutual funds and ETFs are not separated when it comes to disclosure requirements. There is no requirement for an ETF to publish daily holdings, and the decision is up to the asset manager as to what level of transparency is required. If ETFs were allowed to follow the requirements for mutual funds in Europe, given that they're all UCITS products that it would provide greater flexibility to ETF issuers and to how frequent and what level of transparency they would require. Ultimately, the ETF issuer wants to ensure that there is an active arbitrage mechanism for the products and that the spreads and cost remain as low as possible on a daily basis. This would obviously be driven by an effective capital market, which then as a result drives the best outcome for the end investor. Also, regulatory change to allow for an ETF share class of a mutual fund would be a game changer from our perspective for the growth of the ETF active market in Europe, as this model will allow for existing mutual fund managers with highly successful active strategies to enter the ETF market without having to bear the cost of launching a separate ETF strategy. Currently regulation only allows for listed and unlisted share classes of an ETF. There are additional challenges also around having ETF share classes of a mutual fund as you are required to rename the entire fund as an ETF as a consequence of ESMA regulation in 2012. Although the Central Bank of Ireland stated at a recent ETF event in London that the naming convention is on their radar and they would engage with ESMA on the potential to have the regulation changed to remove that requirement. Adding an ETF share class with mutual fund may also have consequences to the beneficial taxation treaties that ETFs domiciled in Ireland currently avail of as listed exchange products. There's a risk that the double taxation treaty on US assets may be lost if the entire fund is not a listed instrument so this is an area that issuers would need to put particular focus when they work with their tax consultants before making a move if it was approved by the regulators. I mean, overall, I think 2022 will see further growth to the transparent active ETF space in Europe with the addition of new entrants to the market although I think semi-transparent products are still a way off. That being said, I think semi-transparent ETFs would only provide optionality to European ETF investors as they would be competing with mutual funds that already exist with similar returns. And we have seen mutual funds starting to offer more competitive prices. So I don't think it'll lead to a huge growth in assets in the European ETF market, but certainly adds optionality.
Frank: All right. This was a great conversation. Thank you all for your perspectives and thank you for taking the time to listen. Please stay tuned for our next podcast on the ETF market and check out our ETF servicing webpage on statestreet.com for more insights. Thank you.