ETFs: Innovation, 401(k) Plans and the Dividend Trade

One of the most interesting and original analysts covering Wall Street is Nicholas Colas, ConvergEx Group chief market strategist.

So we always perk up when he turns his attention to the $1.2 trillion ETF business.

For example, earlier this month he penned a counterintuitive piece about how investors have pumped billions of dollars into ETFs with terrible three-year track records. [Investors By Worst-Performing ETFs]

On Monday he was out with a note featuring high-level observations on the ETF industry, including the role of innovation, how the business may break into 401(k) retirement plans, and the popularity of dividend ETFs.

Below are some excerpts from Monday’s note:

Summary: We recently completed our second quarterly survey of a variety of Exchange Traded Fund (ETF) sponsors, representing well over half of all assets in U.S. listed funds, as well as other opinion leaders in the space. The topic this time around was “Innovation” and its current and future role in further asset growth. While new investment products are always the most visible piece of this topic, our survey respondents had a wide range of additional perspectives. Upcoming changes in distribution channels, primarily in 401(k) plans, was at the top of many lists. One intriguing new topic of discussion was the role of mass-market advertising in long-term brand awareness. As far as important near-term issues, several sponsors mentioned that the uncertainty over personal tax rates in the U.S. could unleash a wave of tax-related harvesting of both gains and losses in the fourth quarter, making the traditionally strong Q4 money flows into ETFs even more pronounced.

I recently had a wide-ranging set of discussions on the topic of “Innovation” with 10 opinion leaders and day-to-day business people from the world of Exchange Traded Funds. Most work for ETF sponsors in a variety of roles, from marketing to product development to C-level management. In aggregate, they represent well over half of all assets in the U.S. listed ETF universe and all major asset classes. As a condition of their participation in this survey, none of their comments are directly attributed to the person who made them.

Here are the most interesting points these thought leaders made in the course of the many hours of conversation:

#1 – Innovation in the ETF industry goes far beyond new products. Since the launch of the SPDR S&P 500 ETF Trust – commonly known as the “Spyders,” now with $107 billion in assets – in 1993, ETFs have grown into a $1.2 trillion industry. Their continued growth over the last five years stands in stark contrast the mutual fund industry, especially when it comes to domestic equity-related products. Over the past half-decade, U.S. listed mutual funds dedicated to this asset have lost almost $500 billion in assets, while ETFs that focus on the same investment class have added $219 billion in assets under management, for example.

One senior executive we spoke to put this growth in a broad perspective, pointing out that a whole range of innovations drove this expansion. There is essentially a virtuous circle of new investors (seeking lower management fees and greater transparency) who invest in ETFs that that interacts with major brokerage firms, which dedicate staff and capital to facilitate ETF liquidity. The result is economies of scale, a central feature of most successful Wall Street business models. As this feedback loop grows stronger and assets grow, ETF sponsors can add incremental and more complex products with the knowledge that the brokerage industry has the infrastructure to support them and investors will take the time to examine their utility. “Liquidity begets liquidity” is a core mantra of the industry, and for good reason.

#2 – As for important trends over the next 12-24 months, most of our industry sources highlighted “Distribution” as a key theme. The specific area of focus was “Defined Contribution” retirement accounts, such as 401(K) plans. There are approximately $5 trillion in assets here according to our respondents, citing published estimates. Retirement assets in self-directed programs (as 401(K) and others are known) are the last great bastions of the mutual fund world, since most firms that provide bookkeeping for these plans built their systems around these investment products.

Several ETF executives we spoke to expect the landscape to change in the next 6-9 months, as several major 401(K) platforms aggressively expand their offerings to include ETF offerings. The names I heard included industry leaders Schwab and Fidelity, and this news has also made its way into the trade press in the last few months, albeit with few details or confirmations. Nonetheless, our industry sources didn’t expect a deluge of new ETF assets as the 401(k) market opens up. The ability to offer ETFs is most attractive to smaller plans – say under $50 million in assets – since larger ones already have access to a wide array of relatively low cost investment choices.

To break into this arena, ETF sponsors will have to develop a range of asset allocation funds akin to the “Target dating” approach used by mutual fund companies. These are essentially equity-plus-fixed income “Balanced” products that alter the blend of the two asset classes based on the age of the investor/employee. Younger folks get more equity, with this asset class’ presumably higher rate of return over the long term; older ones get a higher percentage of bonds.

#3 – Another innovation we heard mentioned several times is the notion of active management. The vast majority of ETF assets are passively managed, hewing to a particular index or commodity price. We heard PIMCO’s name mentioned more than once as breaking some new ground on this front with their actively managed fixed income ETF product. Active management of equity products is a logical follow-on innovation, although progress here is moving along at only a slow pace.

#4 – Marketing/Advertising. One of the hallmarks of the mutual fund industry in its heyday was the “Rock star” equity manager – the Lynches, Neffs and Templetons who became synonymous with the value of active management. Yes, the fixed income industry still has Bill Gross, but the volatility of the last five years have left very few equity managers in a position to act as a credible spokesperson for the merits of “Old school” stock picking.

The most provocative conversation we had in the course of our survey related to what ETF sponsors might do to build their brands among retail investors and institutions. They do not have the ability to use an investment figurehead, in the way mutual funds built their brands in the 1980s and 1990s, of course. But as they face the prospect of marketing to millions of 401(K) participants for the first time, as well as competing in a fragmented ETF marketplace, the topic of brand building is an obvious issue. Should they advertise in mass-market periodicals? Engage celebrity spokespeople? All these venues – and others – seem to be on the whiteboards of many ETF sponsors, almost all of which are very profitable and can easily spend more advertising their products.

#5 – Predict – and follow – risk appetites. When I asked, “What type of investment do you think will gather the most assets over the next 6-12 months?” the answer most often came back: “min vol.” That’s industry shorthand for “Minimum volatility,” of course, and can range from dividend-oriented ETFs, to quality screens that pick “safe” stocks, to algorithms that select equities that have exhibited historically more muted price gyrations. Many of the executives we spoke to specifically mentioned the PowerShares S&P Low Volatility product, which has garnered over $2 billion in assets in a little over a year, as proof of this trend.

Several respondents also called out fixed income as another proof of the rising “Min vol” trend, with the industry adding innovative products to address investor appetites for everything bond related. Indeed, there have been several high-profile launches of emerging market fixed income funds dedicated to corporate bonds which prove out this point.

This trend isn’t just for volatility-shocked retail investors – institutional players such as hedge funds offer a large market for “Vol management” tools. One specialist in such products told me that there are essentially whole suites of “Version 2.0” products in the offing, all with active interest from the hedge fund community. Many will be only appropriate for such institutions, to be sure. But recall the point I made earlier about the virtuous circle between sponsors, investors, and the brokerage community. That feature, which started with plain vanilla products such as U.S. equity market index trackers, is easily leverage-able into highly specialized offerings.

#6 – Innovation plus timing equals success. Every ETF sponsor we spoke with is keenly aware of the seasonality of fund flows into this product. The industry always sees a disproportionate amount of their new capital in the fourth quarter of any year. The reason for this is straightforward: tax loss selling. As investors look to harvest losses in single stocks, mutual funds, and other ETFs, they either reinvest the proceeds in a similarly focused product or swap into another asset type. Properly executed, this exchange minimizes exposure to “Wash sale” rules while giving the asset owner continued exposure to a similar investment type.

Given the uncertainties over the future of the U.S. tax code, courtesy of the Fiscal Cliff and the upcoming U.S. Presidential election, many of our survey respondents felt the fourth quarter of 2012 could be an especially fruitful period for ETF asset gathering. Two examples here:

  • Long term capital gain taxes may well rise to 23.8% in 2013 from their current 15.0%, when you include the 3.8% incremental increase from the Affordable Care Act on high income earners on top of the 5 point increase slated for these gains. Even with the stagnant equity market of the last 10 years, there are many wealthy stock investors sitting on millions – and probably billions – of dollars in long-term capital gains. That’s all dry tinder for the ETF industry, where almost half of the funds on offer weren’t even around just three ago.

  • Dividends will be taxed more like ordinary income, rather than at 15%. The peak rate, again for high earners, will go to 43.4%. How this changes investor appetites for dividends overall is still a wild card, to be sure. But it is a large alteration to the existing tax code nonetheless.

In summary, “Innovation” in the context of the Exchange Traded Fund industry is a multifaceted phenomenon. There are changes underway at every level of the industry’s business model, from distribution to marketing to product development. To my eye, that bodes well for its continued growth. New products get much of the attention, of course, but the foundation for further gains in assets under management is broader that this single feature of the landscape. Innovation in any field seems to enable growth when it spreads the deepest and widest roots, after all.