Responding to the ETF (R)evolution

"This might not be the end, this might not be the beginning, but it is definitely the beginning of the end" ... of traditional, open ended mutual funds (Churchill).

ETFs are popular, plentiful, and eating mutual fund's cake. Their popularity is evidenced by $600 billion in inflows to ETFs over 2023, with outflows from mutual funds show a direct, negative correlation at an estimated $500 billion. Mutual funds will continue to be a mainstay for investments, especially for retirement offerings, but ETFs offer clear foundational differences—namely the improved tax efficiency, more liquidity, and a simpler fee structure. The rise of ETFs has occurred in two primary waves, with innovation on the horizon in our projected third wave:

• Wave one: Early stages of the ETF revolution were driven by the accelerated adoption of passive investment strategies, that coincided with the broader launch of ETF structures. Preference to use these structures for inexpensive beta was readily accepted and delivered benefits to investors of all sizes including pension funds, hedge funds, and "Joe and Jane Mainstreet."
• Wave two (current): The market has reached a new level of maturity where ETFs are a preferred option for passive strategies, in addition to active and thematic hybrids. Consistent flows persist although there is a pronounced skew to largest of the large managers: Blackrock, State Street, Vanguard, Invesco, and a couple others.
• Wave three (projected): A bit further out on the radar but interesting to watch will be ETFs including private and real assets, and potentially, tokenized assets.

This year we’ll find many investment managers launching new ETF products, converting mutual funds to ETF structures (since 2021, over 50 mutual funds with greater than $60 billion have converted), and/or evaluating the introduction of ETF share classes to existing funds following a critical patent expiration. With all that change, how should firms adjust their priorities in response?

1. Aligning the operating model: Alignment is critical for operational functions, administration, accounting, and data related to ETFs as they follow a similar path to mutual fund investment management but with specific timing, tooling, and partner differences. Unique functional processes (e.g. authorized participant facing roles, managing custom in-kind baskets, and others) and the potential need for third-party administrative and distribution-oriented services may be required to unlock new flows while retaining efficiency. And while there are some exceptions, managers that rely heavily on accounting data to drive their investments process are vulnerable to scale issues with ETFs.
2. Intraday and IBOR focus: Timing matters when it comes to ETFs and firms are working to ensure that investments data is accurate, complete, and understood before any basket-related activities—including create, redeem, in-kind, or daily portfolio optimization activities. ETF products are dynamic and intraday activities like corporate actions and reconciliation activity are impactful. ETF's can be related to or mirror mutual funds, but the structures are much more investment book of record-oriented, as opposed to end of day accounting books. IBOR-related projects are key for managers launching ETFs to ensure they can scale their product line up (read more on IBOR in a blog from Citisoft's Mike Maltby).
3. Fixed income, private investments, and more: Managers are now investing in launching fixed income ETF products with growth through fixed income products almost inevitable at this point. Firms that are early in their ETF maturity curve should recognize that while equity products can rely on ETF infrastructure partners to trade/exchange on their behalf, more nuanced, inventory-sensitive fixed income strategies will require more internal attention and support.
4. Asset servicing expanding to "full service": As managers look to simplify operating models with consolidated vendor relationships, providing full service support for both fund accounting and ETF administration will become a focus for service providers with data consistency and critical intraday process support in focus. Firms that offer front to back offerings (portfolio construction through custody and asset administration) are well positioned to partner with asset managers to drive operating model efficiency.

The mutual fund transformed the experience of investing over its 80+ year history but also remains an end of day-based structure in an increasingly real-time world. ETFs are now picking up steam outside of passive investments and the market is ready.  Are you?