Indexing for a new era of ETFs

Technology and innovation will spur the rise of differentiated products and hyper-customization.

Over the last two decades, there has been a drastic change in investor behavior and appetite, largely driven by the innovation in productization, access, and growth provided by the ETF industry.

From fee reductions that revolutionized passive investing and the ETF landscape to the dawn of active ETFs and the unprecedented growth of global markets and new asset classes - the ETF industry has been a beacon of change and opportunity across global finance.

But as we face a new era defined by technological disruption, climate transition, and geopolitical shifts, we must think differently about how to best capitalize on the opportunities and challenges that will present themselves.?

However, with a renewed focus on the original building blocks of the industry and an openness to new ways of collaborating, I believe we can help drive the development of differentiated products that meet the new needs of global investors.

Lower fees are only part of the story

Looking back to 2012 when Vanguard switched its benchmarks from MSCI to FTSE and CRSP, it disrupted not just the ETF market but asset management more widely. It led to a huge inflow of funds to passive ETFs and other fund structures, to the benefit particularly of the biggest passive fund managers who grew rapidly and are now the largest in our industry. It also redefined how much investors should pay for an investment and set in motion a race to reduce fees transforming the ETF industry into the $10 trillion AUM behemoth it is today.

As investors increasingly gravitated to the growing list of low-cost ETF offerings, the passive fee race was on. iShares quickly followed with the launch of its low-cost ‘core’ ETFs. Active managers took notice, lowered their fees, and focused on offering differentiated investment strategies. And today active ETFs are one of the fastest-growing parts of the ETF industry.

Most importantly, the main beneficiaries of these changes have been the millions of investors who now enjoy greater choice and lower fees. And, while the focus on low cost helped propel the industry, the true accelerant has been technology.

A history of change

Technology has spurred innovation across investment development, efficiency, and delivery, broadening US equity access and market infrastructure.

Before 1974, when the Wilshire 5000 was launched, US equities were essentially an institutional marketplace. However, as technology, innovation, and regulation converged, we began to see a drastic change in investor access and investment appetite.

In the 70s we saw the creation of IRAs, the abolishment of fixed brokerage commissions, and the first index fund. In the 80s we saw 401ks developed and the start of the early days for the index industry with the launch of the Russell 3000 and FTSE 100. The 90s ushered in the rise of discount brokers, the first ETF, and first target date retirement plans. And in the 2000s we saw the boom in index funds and passive investing and the early days of robo advisors.

These innovations over the last 50 years paved the way for record retail investor participation. Today over 60% of US adults own stock and there are more than 8500 ETFs listed globally with around $10 trillion in AUM.

And yet I see an ETF industry that is still in its early stages. The significant growth and adoption of active ETFs, innovation in retirement solutions, model portfolios, the shift to tokenization and digital assets, and growing custom solution capabilities are a testament to the innovative nature of the ETF industry – one that will continue to evolve with the needs of investors.

And as I look at the next 50 years for the ETF industry, I believe the focus will no longer be on low-cost or even active vs passive. It will be squarely on investment outcomes and how those outcomes are achieved through the development and delivery of modern and differentiated products.

But the only way we can achieve this is through a deeper understanding of markets, modernized index construction and true collaboration.

Equity markets are smaller and more concentrated

Today’s global markets look markedly different than they did almost four decades ago, but many of the core equity benchmarks look the same as they did when first launched.

Looking specifically at the US - the combination of fewer listed stocks, the significant increase in stock concentration, and a total return of circa.600%?since 1998 is not properly reflected in the older legacy indexes or adequately explained by the market definitions we have become reliant on.

Why does this matter?? Well, the characteristics and performance of different segments of the market can be very different. Investors use indexes to understand risk and gain exposure to these segments based on their own risk tolerance. If indexes do not represent the different segments of the market accurately, investment decisions become based on false assumptions. ?

This has very real consequences, spanning performance and cost to end investors, fund managers and issuers with products tied to these indexes – and these issues go beyond core equity indexes. Global equity index series suffer from opaque methodologies due to a patchwork of ‘fixes’ over the years.

Most notably, underlying industry classification systems haven’t evolved with the ongoing digital transformation over the last two decades, which has rapidly changed the dynamics of the global economy. This transformation has fueled the rise of new industry sectors and sub-sectors that are redefining?traditional industries and where companies truly fit - all ultimately impacting index construction and investment outcomes.

And while factor investing has grown significantly over the last decade, we are now seeing how many of the early factor index designs are off target.

These early factor index designs use factor signals but tend to pick up a tail of other characteristics which distorts performance. Different factors also decay at different speeds which need to be considered when combining factors and determining review frequencies.

Greater availability of data combined with advanced machine learning and AI capabilities now allow us to apply long-established financial theory in a way we could not conceive before. The outcome of this are our targeted “pure factors” which are specifically designed to reduce the extraneous variables and exposures enabling the investor to isolate the on-target factor attributes.

Ultimately, changing market dynamics need modern indexes that are adaptive and provide appropriate future proofing.

The distinction between active and passive is becoming blurred

As technology continues to advance at an amazingly quick pace, it will further blur the lines of active and passive investing and drive greater demands for personalized investments.

To meet the growing personalization needs of global investors, the industry will need a mix of tools, technology capabilities, expertise, and data.

Mitigating climate risk in a portfolio will also evolve. As the physical impact of climate change increases in our daily lives, investors will begin to shift to sectors and companies focused on building climate adaptation infrastructure.

New asset classes and operational efficiencies will require innovative approaches. ETP providers will have to explore tokenization, as the next generation of investment wrapper, which also offers access to private asset classes and investments.

The industry can help achieve success with these challenges and opportunities through collaboration.

Looking to the future

Data and technology will ultimately drive investment practices and index creation in the future. And because of these fundamental changes, the relationship between supplier, intermediary and end clients will change and become far more collaborative.?

To truly propel the industry forward for the next 50 years, we must transcend traditional models and embrace a new era of collaboration and innovation. Increasingly, partnerships will be more highly valued and the most successful index providers will have collaborative partnership relationships with their clients.

Through the exchange of data, technology and ideas, the industry can continue to create truly innovative and differentiated products that will give every investor, regardless of background or location, access to tailored investment solutions that meet their evolving needs.