While many are undoubtedly excited to put the whirlwind year that was 2020 in the rearview mirror, those of us in the exchange-traded fund (ETF) space may simultaneously see 2020 as a pivotal year for the product. From the adoption of the ETF Rule (6c-11) to the first Active Semi-Transparent ETFs hitting the market to the critical role the product was for investors managing the worst market downturn in over a decade, ETFs were in the news all year long. Through it all, it was a year for the record books: the U.S. ETF market took in a record $507 billion in new assets through year-end.1 It has been a wild ride for sure, but it could turn out to be just the beginning. Here are some of the highlights we have seen in the ETF industry during 2020 and a look at what we may expect this year.
Industry Standardization in the U.S.
Back in the fall of 2019, the SEC announced the much anticipated “ETF Rule,” officially known as Rule 6c-11. This change in how ETFs are regulated was driven by a desire to have a consistent and transparent framework across the industry. Two of the most important components of the rule were:
- The elimination of the requirement for ETF’s to obtain exemptive relief. In doing so, the process to launch ETFs by issuers becomes standardized and less expensive.
- A level playing field for all ETFs regarding the use of custom baskets. The SEC stopped granting the use of custom baskets within exemptive relief orders back in 2012, and only issuers with existing exemptive relief who were grandfathered in were able to leverage non-standard baskets for creation/redemption activity. With the new rule, all ETFs can utilize custom baskets, potentially resulting in significant tax efficiencies for the funds and its investors.
While the Rule went into effect in December of 2019, issuers had a full year to become compliant. In response to the adoption of the ETF Rule and an increase in custom basket orders across the industry, the National Securities Clearing Corporation (NSCC) implemented enhancements in July 2020 to enhance and standardize the creation/redemption process between ETFs and the authorized participant (AP) community. As part of these enhancements, new basket types were introduced allowing for multiple baskets to be published nightly to the street. They also improved the labeling of each basket to its specific use. This allowed APs and market makers consuming the daily baskets to see all of the constituents for creation, redemption, rebalance, and the newly introduced pricing basket. The last of which is an attempt to standardize the full fund holdings being disseminated, allowing the APs and market makers to more accurately price the fund throughout the trading day through a centralized data source.
Holding Their Own in Volatile Markets
During the market sell-off that saw the S&P 500 fall 12.5% in the month of March, ETFs surprisingly saw net inflows over the same period with U.S. listed ETFs seeing an increase of $176 million.2 Of even greater significance, research by The Investment Association noted that ETFs acted as a source of stability and price discovery during the month.3
While many market observers noted that fixed income ETFs were trading at large discounts to NAV, this is evidence of the ETF wrapper working exactly as designed. APs and market makers were able to trade the ETFs using a more accurate valuation of the funds underlying securities compared to the stale price they were being marked at and could leverage the creation/redemption mechanism to arbitrage away discrepancies. This allows the ETFs to act as a price discovery tool, providing for real time valuations of the basket components. At a time of significant market stress, investors were turning to ETFs as a result of their transparency and, most importantly, their liquidity, as evidenced by ETFs accounting for approximately 40% of market trading activity in the U.S. and 30% in Europe during early March.
Maybe the biggest story in the industry in 2020 was the continued rise of Active ETFs. While not necessarily new when it comes to fully transparent funds that are actively managed (which have been around for years), this year saw the first Active Semi-Transparent ETFs come to market. While these innovative products look and feel like any other ETF to investors, their distinguishing feature is the fact that they are not required to disclose their actual full fund holdings to the public daily.
Active Semi-Transparent funds currently stand at around $800 million in AUM across 15 funds since launching in March.4 One of the main concerns with these strategies that had kept them on the sidelines historically was with market makers having the tools and data to accurately price the funds, which would result in wider spreads driving up secondary market trading costs for investors. To date, spreads on all the listed semi-transparent ETFs have been surprisingly tight signifying that these new products are working as intended.
These continue to be a key element of potential product development plans for active managers in the U.S. and regulators in Europe are closely monitoring these products as managers are looking for similar solutions in that market as well.
2021 and Beyond
After the milestones reached in 2020, what could the industry possibly have in store for an encore? With the ETF Rule now in place and the introduction of various structures within the ETF wrapper available for asset managers to bring their products to market, there is amble opportunity for continued growth.
In Europe, the Central Bank of Ireland (CBI) have openly stated that they have recognized the developments in the U.S. and are in discussions with parties within the European ETF eco-system to develop their thinking. This work is at an early stage but progress is expected in 2021.
One key area to keep an eye on in the U.S. will be the first executed conversion of an Open-End Mutual fund to an ETF. In the last few months, three firms have announced their plans to convert their products which could be completed in the first quarter. Once a successful transition event has been completed we expect to see the floodgates open. A conversion would allow managers to give existing shareholders improved tax efficiency along with lower costs, while porting their performance track record as part of the transition. In Europe, a number of mutual fund to ETF conversions have already been implemented and some firms have used the transition to enter the ETF market with scale right out of the gate.
These just begin to scratch the surface. Renewed focus on Bitcoin ETFs, enhancements in ETF distribution, and consistency in ESG methodologies are just a few of the potential headlines for 2021. As 2020 has shown, the growth and evolution within the ETF market may have only just begun.