The Coming $50 Trillion Rotation Into ETFs Will Permanently Change Financial Services and the Markets

The end of 2019 was full of major news. Beyond the impeachment, there is a phase-one agreement to a trade deal between the United States and China, and Boris Johnson scored a major political victory for Britain’s Brexit move. The stock market continues to hit all-time highs day after day, and the Federal Reserve has communicated that the current federal funds rate is appropriate enough that the markets should expect little or no real interest rate moves in 2020.

While this bull market of a decade-plus has become the longest of our lives, it also has been one of the most unloved, mistrusted and disrespected bull markets we have ever seen. One area of the financial markets that has grown like wildfire in the past two decades is the rise of exchange-traded funds (ETFs) and exchange-traded products (ETPs). There seems to be an ETF or ETP out there for almost any strategy you can think of. There is even a quote everyone should know now and going forward: “We have an ETF for that!” That is proved by the rise and fall of leveraged ETFs, and strategies for short selling and hedge fund strategies, as well as sector-focused ETFs in cannabis, rare earth metals, gold, semiconductors, artificial intelligence, coal, alternative energy, oil and gas, and countless more.

While the rise of ETFs is already projected to be more than $5 trillion as of 2020, Merrill Lynch is expecting the market for ETFs and related products to rise to about $50 trillion over the next decade. That is not necessarily a call for the stock market to rise tenfold over that period by any stretch. It just means that investors are likely to focus more on ETFs and ETPs in lieu of direct stocks and bonds and in lieu of mutual funds and other individual asset classes. If there really is (or will be) an ETF for any strategy imaginable, it’s easy to see. Investors also don’t have to worry about fees inside of ETFs as much as they do inside of mutual funds, and there generally aren’t multiple classes of an ETF with varying fee structures that are even difficult for many financial advisors to try to explain.

The S&P 500 SPDR (NYSE: SPY) is the king of all ETFs. The website lists it as the largest of all U.S. ETFs with nearly $300 billion in assets under management. That said, the iShares Core S&P 500 ETF (NYSE: IVV) has almost $200 billion in assets under management, and adding up the next six ETFs by size from the website comes to $1 trillion in assets.

Mary Ann Bartels, Investment and ETF Strategist for Merrill Lynch issued a report this week signaling that the broad ETF market would hit $5.3 trillion by the end of 2020 and then $50 trillion by 2030. Needless to say, this is going to involve many strategies and create a great rotation that will be a victory for some companies and may make some investment management firms feel as though they were in the business of monitoring cigarette sales in the past three decades.

The driving forces for the coming decade will be costs and fees, a continued move to passive investing, an increased awareness of tax efficiency, liquidity of the products and their transparency. There are some trends to watch out for as well.

Again, the move to $50 trillion is not just a rotation into stocks. Bartels sees fixed Income ETF flows continuing to see more funds coming their way (“punching above their weight”) in 2020. International equity ETFs may get more interest as well in 2020. Thematic ETFs are expected to see strong growth, while the “non-transparent active ETFs” are expected to remain “a show-me story.” Bartels also noted that ETF stock ownership has a limited impact on market liquidity. She said:

We find that historically, there has been only a small difference between the average bid/ask spread for S&P 500 stocks that are the most held and least held by ETFs. The fundamental mechanics of the ETF structure combined with the functions of market participants across the broader ETF ecosystem suggest that there is more to the ETF impact on overall equity market liquidity than meets the eye.

Other trends were noted as well. In a slate of Relative Value Ideas, Bartels sees State Street generally over iShares industry ETFs (relative value in equal weight industry ETFs over market cap-weighted ETFs). Some relative value ideas by sector and in other ETFs by ticker were named by Bartels and other team members on strategy:

  • Biotech (XBI over PBE)
  • Semiconductors (XSD over SOXX)
  • Banks (KBE over FTXO)
  • Small over Large in U.S. equities (VO, JHMM)
  • Global to Local with trade wars (RGI, FEZ, EWJ)
  • Growth to Value (LRGF)
  • Financials/Banks: Value, Local & Yield (IYF, KBE)
  • Hedging 2020 with Gold Miners & Utilities (GDXJ, RYU)

The full report is 24 pages of data before getting into the disclosures, so needless to say there are many points that were to be made. That said, the financial services industry has been on a fee-destruction path for more than two full decades now. It sounds like this next decade will be the time when the greatest changes ever are seen.

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