How have ETFs evolved over the last few years?
One of the biggest themes in ETF evolution over the last few years has been in the increase in scope of products offered to the market. With increased competition, new launches are now targeting gaps in investors’ universes with more specific products. This has been witnessed across asset class as well as developments in actively-managed funds being launched in an ‘exchange traded’ wrapper. Some more recent examples would include funds tracking crypto, ESG or other fundamental factors such as quality or income.
This increase in product type has widened the pool of prospective investors – both institutional and retail – and the competitive nature of the industry has seen costs reducing, which in turn brings ETFs to more investor’s attention. This expansion in both client-base and products has led to a rapid growth is assets and trading volumes.
Consequently, ETF trading techniques have evolved to source new pricing opportunities either via electronic Request For Quote (RFQ) platforms and/or ETF algos and to take advantage of ETF trading provision at the exchanges themselves. We have also seen traditional ETF liquidity provision firms moving into forming bilateral relationships with buys-ide dealing desks which has further strengthened ETF pricing. Finally, there has been significant innovation in the ETF post-trade analytic capabilities for traders – either developed inhouse and/or utilising third party solutions creating a deeper understanding of implementation costs which can be used to improve future trading outcomes.
What role are active ETFs playing in the progression of this asset class?
When the investment backdrop becomes more challenged, investors have to take greater consideration of investment risk rather than simply buying market exposure (beta) in order to generate positive returns. Actively-managed ETFs complement a passive approach, by providing access to specific investment processes designed to achieve specific results such as index outperformance, income generation, or factor tilts such as quality, duration or yield, all while maintaining the attributes of the ETF structure.
Active ETFs have been released across different asset classes and have appealed to new and old ETF investors alike as they provide middle ground between passive & active investing. Through active ETFs, managers are able to offer access to internal intellectual property and house expertise such as bottom-up stock research, allocation weightings etc that not only differentiate their product but can help investors generate alpha for a portfolio alongside core passive holdings.
What are the impacts of fragmentation linked to ETFs?
The most obvious impact of fragmentation has been on the perception of an absence of secondary-market liquidity. This has mostly likely, held back some adoption of ETFs from investors but has also led to increased innovation from all market participants to source, aggregate and efficiently price ETFs. RFQ platforms have taken the lead for traders when seeking risk prices as they reduce the opportunity cost of requesting prices from multiple liquidity providers but in an information-controlled manner. Traders have also adopted more dedicated ETF trading algorithmic strategies launched to empower dealers with the ability to access a wider range of liquidity pools at differing urgency settings which alter the child-order placement logic, often within fair-value frameworks.
On the opposite side of the trade, market makers and liquidity providers constantly search to improve efficiencies within their processes to better utilise their balance sheets to offer tighter pricing and/or greater liquidity. Fragmentation, however, means that market makers have to disperse their liquidity among multiple exchanges and trading venues reducing the volume available in each. Additionally, the costs associated with post-trade fragmentation (Central Counterparty Clearing & Central Securities Depositories) further reduces the cash market makers can commit into the market, instead having it tied up to satisfy post-trade provisions.
What can be learnt from the US?
Aside from the simpler US ETF market ecosystem, the European ETF market would greatly benefit from increased retail ETF adoption and participation as seen in the US. Technology firms are looking to help platform providers streamline the ETF process, reducing complexity where platforms may currently struggle due to legacy systems, in order to increase/improve the ability of platforms to offer more ETF trading to their clients. Increasing adoption of ETFs from the retail community combined with improved connectivity from platforms to exchanges creates opportunities for buy-side dealers to interact with these improved volumes on exchange as professional and retail volumes create a better dynamic for orderbook trading.
Improvements could also be made in financial education – from school age through to adult investors. With greater demands being placed on individuals’ long-term savings capital, a deep and sound knowledge of all financial products would encourage people to take more control of their investment solutions at an earlier age and low-cost ETFs are well placed to form part of their investment toolkit.