Exchange-traded funds: The race for innovation in ETFs

From smart beta products to artificial intelligence, Benjamin David explores the trends shaping the ETF market.

Innovation in the exchanged-traded fund (ETF) sector has been rapidly increasing lately, resulting in increased use by investors. With their ability to track a specific index, commodity or market segment, and the ease with which they can be bought and sold like stocks, ETFs have become popular for their low fees, ease of access and versatility.

Their performance in recent months has been impressive, with net inflows in November reaching €14.3 billion, according to data provider Refinitiv. What’s more, evidence suggests that for institutional investors and wealth managers, the appeal of ETFs shows no sign of waning.

Consider a survey by HANetf, one of the leading platforms for ETFs and exchange-traded commodities (ETCs). When it polled 100 institutional investors and wealth managers – collectively responsible for $67.1 billion of assets under management in Germany, Switzerland, Italy and the UK – it found that 33 had “dramatically” increased their use of ETFs and 54 had “slightly” increased their use in 2022.

In total, 81% planned to make more use of ETFs over the next 12 months, with 17% looking to do so “dramatically”.

ETFs and innovation

The burgeoning use of ETFs is down to their cost-effectiveness, liquidity and transparency, according to Dami Sotande-Peters, assistant vice president at State Street SPDR ETFs. “ETFs can offer beta exposure at an ultra-low cost, rivalling traditional institutional investment vehicles, making them an attractive alternative for investors,” she tells Funds Europe.

The increased accessibility and efficiency across digital platforms have also contributed to a surge in popularity amongst retail investors, she says.

Among institutional investors and wealth managers, the sector’s reputation for innovation is another draw. New ETF developments have enabled fund managers to design bespoke strategies, says Sotande-Peters. “ETFs have also emerged as an attractive alternative to futures, as they can be implemented without the daily margin requirements or the infrastructure, administrative and legal and compliance overheads that come with derivatives.”

“ETFs have emerged as an attractive alternative to futures, as they can be implemented without the daily margin requirements or the infrastructure, administrative and legal and compliance overheads that come with derivatives.”

Alongside ‘traditional’ core equity and fixed income investments, she also highlights a growing interest in ETFs to implement exposures formerly limited to active managers, such as factor, thematic or smart beta strategies.

Professional investors recognise the high level of innovation in the ETF sector, explains Hector McNeil, co-CEO and co-founder of HANetf. This is particularly true when ETFs enable investors to tap into different asset classes and lower charges than mutual funds provide.

“Analysts argue that investors should be allocating funds on a thematic basis rather on geographies, and ETFs provide a way to do that so that funds can be invested in companies delivering strong returns irrespective of where they are based,” adds McNeil.

Smart beta ETFs

One key trend is the rise of smart beta ETFs. The value-based variety outperformed traditional strategies last year, which some experts say will revive the fortunes of smart beta in Europe.

Smart beta ETFs use alternative index construction methods that weigh securities based on value, momentum or quality. This contrasts with traditional market cap-weighted ETFs, which weight securities based solely on their market capitalisation. As a result, smart beta ETFs offer investors the potential for better risk-adjusted returns and have become increasingly popular in recent years.

Assets under management of European smart beta ETFs were €93.7 billion by November 2022, compared to €102.1 billion in December 2021, according to ‘The Cerulli Edge-European Monthly Product Trends’ report. It also reported that total net European inflows into value funds stood at €15.1 billion in October last year, falling just €0.7 billion short of the inflow figure for December 2021. Despite performing worse than value, quality strategies could outperform the former in 2023 since they tend to perform better during recessions, says Fabrizio Zumbo, European asset and wealth management researcher at Cerulli Associates.

European smart beta ETF issuers expect the highest asset growth in the UK market over the next 12-24 months: “Smart beta growth across Europe will depend on how these factor-based strategies perform during the challenges that 2023 brings and whether this performance is enough to attract investor flows,” says Zumbo.

Manager, AI, ETFs

Actively managed ETFs

Another notable trend in the ETF sector is the creation of actively managed ETFs. While most ETFs are passively managed and track a specific index, a minority are managed by professional portfolio managers who use their judgment to select the securities in ETFs. This allows for the possibility of outperforming the underlying index, but comes with the risk of underperforming.

A January 2023 ‘State of the Market: Future of Retail Products’ report by ISS Market Intelligence expects active ETFs’ market share to rise from 1.4% to 2.3% by the end of 2027. This represents 17.4% annualised growth in assets under management and more than $280 billion in new flows. The report notes the potential for rapid growth has already spurred heavy product development activity, with the number of active ETF launches far outpacing any other product categories in 2021 and 2022.

Artificial intelligence

In addition to these trends, the ETF sector has seen technology used to innovative effect. Artificial intelligence (AI), particularly machine learning algorithms, has allowed for more efficient and cost-effective portfolio management. Some ETFs use these technologies to analyse large amounts of data and identify investment opportunities that would otherwise require more work for a human portfolio manager to uncover.

Asked to fashion a market-beating portfolio, the AI-based ChatGPT tool purportedly told users that the stock market isn’t predictable enough. By contrast, the $120 million AI Powered Equity ETF (AIEQ), issued by ETF Managers Group, claims to have done so this year. AIEQ, launched in 2017, uses the power of IBM’s Watson supercomputer to select its portfolio holdings.

So far, it’s performing well: more than 14% in the year to January 27, according to Morningstar. That’s about double the S&P 500’s year-to-date return of 7%. The fund leverages machine learning, sentiment analysis and natural language processing to select the stocks in its portfolio. The portfolio, meanwhile, analyses companies via four quadrants: financial analysis, news, management and macro.

What else?

Given these three major trends, a further question remains: “What else?”

The overall ETF market drive remains the same, says Sotande-Peters: using ETFs for “long-term core allocations and gaining exposure to more difficult-to-access markets”, such as convertible or emerging market local bonds.

The sector is changing significantly – and with the rise of smart beta ETFs, actively managed ETFs and advanced technology, it looks like the ETF market is working hard to increase accessibility and efficiency for institutional investors and wealth managers.