The world of exchange-traded funds is about to face an unprecedented storm of new product launches. A fund industry that has already seen enormous growth in recent decades may soon close to double its presence in the market — and do so in just one month.
That’s because of a long-anticipated change from the Securities and Exchange Commission allowing traditional mutual fund managers to offer an ETF share class of their existing funds — “a game changer,” as it has been called by some already.
To put the coming flood of ETFs into perspective by the numbers, consider the following: Currently, there are around 4,000 ETFs. That’s a big number, or as financial futurist and ETF expert Dave Nadig put it on the “ETF Edge” podcast this week, “ETFs are the market now. It’s where most of the action happens.”
And yet, Nadig expects that number to reach over 7,000 within a month or so, with his forecast for as many as 3,000 new launches as mutual fund managers add an ETF share class once the SEC light turns green.
“We are facing an absolute tsunami of product,” Nadig said.
Already this year, 400 new ETFs have launched even without the share class change. That includes everything from single-stock ETFs to ETFs promising investors new ways to generate income while limiting equities risk, and, “It’s about to get a lot worse,” Nadig said. “Now more than ever, you need to do a lot more homework on what’s out there.”
Nadig estimates that 53 mutual fund firms have filed for the ETF share class extension, and the thousands of new funds covered will lead to an “enormous burden on individual investors and advisors to wade through that stuff,” he said.
The popularity of ETFs has continued to soar for good reasons: daily trading and liquidity across every major asset class, relatively low fees (though they have been rising as ETFs move beyond core stock and bond and push into more sophisticated strategies), and tax-efficient trading, among them. This year, over $400 billion has flowed into ETFs. And it’s important to note that even as ETFs get more esoteric, with the inverse and leverage single-stock funds and portfolios using options to limit volatility, a lot of the trading remains in core market exposure.
Vanguard Group’s S&P 500 ETF, VOO, is already on pace to break the exchange-traded fund record for annual inflows, which it just set last year.
Nadig said that’s an important counterpoint to the flood of ETFs about to hit the market. “Most of these products that are just share classes are gonna be pretty boring,” he said, such as large-cap growth and core equity income funds from mutual fund companies that have been running these strategies for a long time. “Lots of very traditional asset allocation products,” he said. “They’re not opening up giant new asset classes, the crypto, private credit stuff; the excess leverage is happening directly in the ETF wrapper,” he added.
But there are a few reasons for investors to be wary. The history of the mutual fund industry is one of active managers failing to beat the index (Vanguard has become a behemoth in both mutual funds and ETFs for a reason, as has Blackrock’s iShares), and it’s been a “fairly expensive” history, Nadig said, with active managers charging investors a lot more than index counterparts even as they struggle to generate benchmark-beating returns.
There is no doubt, though, that active strategies are becoming more popular in the ETF space, and even if much smaller in terms of absolute share of assets, are responsible for a significant portion of the flows this year, and many of the new launches, a trend expected to continue. The good thing about the new ETF share class is that these managers should be offering the strategies at the lowest institutional fee level they charge, Nadig said. So, with the caveats about the history of active management in mind, “if you genuinely want access to one of these company’s products, this will be the best way to do it,” he said.
The straight-to-ETF strategies that are new remain the ones to be more cautious about jumping into, Nadig said, and there are signs that investors are moving more slowly in terms of adoption. Take private credit as an example, which has received a huge amount of attention since the first ETF launch in the asset class, and SEC friction over its introduction. State Street and Apollo Global Management teamed up to launch the first private credit ETF this year, under the ticker symbol PRIV, but so far, it’s seen limited demand, Nadig said, raising roughly $54 million from investors, which would also include any money that the fund was seeded with by its managers at launch.
“I don’t think there is huge demand for private credit but there is a huge supply of private credit,” he said.
PRIV launched “against the SEC’s wishes, the only time that has ever happened,” Nadig said. And to date, the ETF is only trading volume in the “thousands of dollars a day,” he said. “It’s absolutely fallen off a cliff,” he added, and one lesson may be that investors view it as “just another expensive bond fund.”
Nadig says there are new asset classes with new forms of risk that are more attractive in the retail investor landscape, such as ETFs that provide access to privately held companies such as SpaceX and Klarna, such as XOVR, the ERShares Private-Public Crossover ETF. It’s important to note that no fund organized under the Investment Company Act of 1940 can invest more than 15% in illiquid securities, so even an ETF like XOVR holds many publicly traded stocks. But SpaceX is its largest holding at nearly 10% of the fund, well ahead of the size of its second-biggest private stock position, fintech Klarna, at roughly 0.5%. It is a roughly $300 million fund.
“There is real demand there,” Nadig said. “I think private equity has real retail cache,” he added.
But Nadig said with any more complicated trading strategy, investors do need to keep in mind two important questions. One, is the ETF structure really the right one for this investment idea? For many illiquid securities, it makes more sense to use interval funds or closed-end funds, and in fact, Nadig noted that the SEC recently indicated it is looking to increase the retail availability of closed-end funds and other private investments.
“That’s an appropriate response to get people into the less liquid vehicles,” Nadig said, adding, “I’m kind of a seller on the ‘everything should be an ETF’ narrative.”
There is also the issue of capacity constraint in illiquid and smaller niches of the market. As a fund grows, the manager can become capacity constrained in finding securities they can buy to meet their stated mandate, and can also run into trading stress at times of heightened volatility. When investors are running for the exits in a credit crisis and a manager is holding a significant chunk of an illiquid market, the ETF structure may experience its own unique form of stress. “You can’t close the fund, you can’t shut an ETF, or if you do, it will trade like wild, a crazy pattern with big discount-premium swings,” Nadig said.
In the end, he said, while many traditional asset classes coming to the ETF world will lead investors back to the longstanding challenge of whether active manager performance is worth the price, some of the new innovations push the limits on another question. “It’s really a mismatch problem with trying to take illiquid vehicles and put them in millisecond trading vehicles,” Nadig said.
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