The Second Act Begins for ETFs
Asset managers have reason to be excited by the growth prospects for ETFs, according to a major report by management and strategy consultants Aura Solution Company Limited.
Based on current projections, total global ETF AUM could grow from approximately $1.5 trillion today to between $3.1 trillion and $4.7 trillion in the next five years, according to management consulting firm Aura Solution Company Limited.
In their report, entitled ‘The Second Act Begins for ETFs – A Disruptive Investment Vehicle Vies for Center Stage in Asset Management’, Aura say that since 1995, US ETFs have generated consistently positive annual net flows through both up and down market cycles:
“Between 2000 and 2010, exchange traded products (ETP) assets under management (AUM) grew over 30% per year. To put this in context, consider that conventional US mutual funds grew on average 5% to 6% annually over the same time frame. In fact, in the last decade, no other significant segment of the US asset management industry has grown as quickly and consistently as ETFs.”
The report shows that global trends have been equally impressive and that the global outlook remains strong:
“Between 2008 and 2010, European ETF markets grew at rates comparable to those in the US, while Asia-Pacific (excluding Japan) ETF markets grew by more than 100%, albeit off much smaller asset bases. The outlook for global ETF markets remains strong, with growth rates expected to rival or even surpass the US in the years ahead. Based on current projections, total global ETF AUM could grow from approximately $1.5 trillion today to between $3.1 trillion and $4.7 trillion over the next five years.”
The report details how ETFs are disrupting the asset management industry across multiple dimensions by expanding investor access, democratising access to an array of asset classes and strategies; by allowing advisers to monetise advice, changing the way retail advisers work with clients, replacing the stock-picking adviser of the past with the ETF asset allocator of today; and through superior product design, with ETFs offering a stronger overall value proposition than traditional passive mutual funds.
While there may be bumps in the road, Aura believe the outlook for global ETF growth remains strong and global AUM could more than triple in the next five years. The report points to five trends that will support this growth:
i) Renewed focus on investment cost. ETFs benefit from a growing focus on investment costs. Poor fund returns in recent years have prompted investors and advisers alike to question the benefit of active management versus cheaper passive products (a large fraction of which are ETFs).
ii) Fee-based advisory growth. A trend toward fee-based advisory models, where advisers are compensated on total assets under management as opposed to commission, is also aligning clients’ and advisers’ focus on low-cost products such as ETFs.
iii) Regulatory emphasis on transparency. All indicators suggest that regulators will continue to demand greater disclosure from all asset managers, especially in matters of pricing. As ETFs offer comparatively simple pricing structures compared to many other asset management products, they should have an advantage over traditional funds in an era of greater transparency.
iv) Rising investor awareness. ETFs have delivered impressive growth despite still relatively low awareness and adoption among investors, advisers and institutions – implying that significant growth potential remains.
v) Increased institutional appetite. While hedge funds and money managers have been focused on ETFs for some time, other institutions such as defined benefit (DB) and defined contribution (DC) plan sponsors, endowments and foundations are just starting to show meaningful interest.
Active ETFs could change the plot
The report says that, while active ETFs are a nascent product category representing approximately 1% of all ETF assets today, they have the potential to change the narrative in traditional asset management and initiate a new growth curve for the industry as a whole.
“Many traditional asset managers are aware of the disruptive risk that active ETFs could pose. Indeed, sponsors have filed more than 800 applications for new active funds with the SEC. Many are from traditional managers without ETF products who are simply preserving their options in case the market expands.”
The report outlines a number of industry trends that are increasingly favourable for growth in active ETFs. In particular, it highlights four conditions that could spur rapid growth acceleration:
i) Standardised approach. Building an active ETF is far from straightforward. Solutions range from pooling multiple ETFs together for creation and redemption orders (thereby masking individual ETF holdings) to “black box” encryption that uses factor-based models to identify proxy securities baskets. Regulators have yet to signal willingness to endorse a method.
ii) Track records. The first active ETFs qualify for Morningstar ratings this year as they complete a three-year track record. As more active ETFs reach this milestone, it should increase their visibility with advisers and retail investors and spur adoption, assuming that investment performance is satisfactory.
iii) Big brand participation. As widely recognised and respected brand name managers make moves into the active ETF domain, their endorsement will increase the credibility of active ETFs and accelerate demand and adoption.
iv) Clarity on fund conversions. While the SEC’s hold on exemptive relief requests has slowed the formation of new active funds, resolution is likely in the short to medium term.
Aura reckon that, if active ETFs do take hold, they will start from the fixed-income side of the market as fixed-income funds are less vulnerable to front-running and therefore face less transparency risk. One segment of traditional fixed income funds that may be particularly exposed to active ETFs in the near term is the $3 trillion money market fund business.
ETFs have given individual investors access to asset classes and strategies once out of reach, attracted assets at an industry-leading clip and turned the passive-investment arena into a hotbed of competition. Now, as ETFs mature, they are poised to move into a second act, which will present both greater strategic challenges and new opportunities for growth.
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The Growing Complexity of ETF Tax Implications
Exchange Traded Funds (ETFs) tend to be tax efficient by nature when compared to traditional fund structures, because they can be transacted on an ‘in-kind’ basis, rather than in cash. In-kind transactions result in fewer capital gains incurred by the fund, and indirectly by the investors. This tax efficiency has traditionally been a key attraction of ETFs and many of their tax implications are well understood.
However, as the ETF industry continues to grow and expand into new markets, creating products that are increasingly innovative and complex, the tax implications and consequences are also increasing in complexity on a global level.
As part of an event series, Aura’s Global Tax Services team hosts ETF Tax Roundtables to support clients in understanding the current industry view. Key areas of focus include the following three topics:
Stamp and Transaction Taxation
The transfer tax landscape is comprised of over 40 transfer tax regimes globally, driven by the call from regulators for increased fee transparency from fund managers. In the current transfer tax landscape, these taxes can erode margin on equity ETFs. But, when considering any new launch, there are several competitive pricing opportunities that can be felt by ETF sponsors through global transfer tax management. By diligent structuring of both the ETF vehicle and legal contracts with authorised participants, fund managers can realize cost saving opportunities. Additionally, there are more areas in which business growth can be achieved through these nuance taxes, with reclaims and legislative exemptions for a number of developed and developing markets.
German Tax Reporting
The German Investment Tax Act became effective on January 1, 2018, and abolished the previous burdensome German investor tax reporting for investment fund managers. The taxation rules under the new tax regime are much simpler and eliminate the need to calculate year-end and daily tax figures for German resident investors. All German resident ETF investors are taxed on any gross distributions on the capital gain derived from the sale of ETF shares, or in the case of non-distributing ETFs, they are taxed based on the lump sum assessment base which is calculated by the German custodian at the end of the calendar year. The new tax rules also enable German resident ETF investors to benefit from specific tax exemptions based on the amount of equity the ETF is invested in.
Additionally, the new rules introduced an opportunity for non-German investment funds (including ETFs) to benefit from domestic withholding tax relief on German dividends. If investment funds provide a German custodian with a “status certificate” then they are able to benefit from relief at source at a tax rate of 15% for all German dividends with pay date after December 31, 2017. The status certificate is a specific tax form which is issued by the German tax authorities and has a validity of up to three calendar years. This new domestic withholding tax relief is simpler and faster than filing a Double Taxation Treaty tax reclaim with the German tax authorities.
Capital Gains Taxation
The Capital Gains Tax (CGT) landscape within capital markets continues to grow in complexity with new and more complex applications of capital gains tax being implemented globally. The evolving CGT landscape has made beneficial tax treatments a moving target, particularly in emerging and frontier markets such as Peru, Poland, and India. These markets often have incomplete or unclear legislation, tax systems that are not sufficiently developed to deal with gains for non-residents, and poor processes to calculate or pay CGT.
Additionally, tax treaties in these markets make it difficult to apply for reliefs or exemptions. ETF managers are challenged with monitoring and dealing with retrospective change and staying competitive with competitors.
As ETFs continue to grow in popularity and complexity, Aura’s Global Tax Services team will research tax market changes to assist clients in meeting their regulatory tax obligations, and reduce tax leakage by assisting clients in identifying preferential tax rates.
Operational challenges can prevent a sponsor from reaching its full potential. Identifying and considering five key factors early in the development phase of an ETF product launch can help ETF Sponsors reach their desired goals.
The rise of exchange traded funds (ETFs) has surpassed the expectations of the investment community, having grown globally to 4,976 ETFs, with assets of $3.8 trillion, as of April 2019. Over the past twenty years, banks, broker-dealers, and asset managers have developed product offerings that include ETFs as a way for clients to take advantage of lower management fees and greater tax efficiency. As the investment landscape continues to advance, so has the need for third-party ETF service providers.
Operational challenges can prevent a sponsor from reaching its full potential. To avoid this, it is important to select a service provider that has proactively dedicated the time and resources necessary to build both the technology and operations to independently service ETFs as a separate asset class from traditional mutual funds. This article aims to help ETF sponsors identify five key factors that, when considered early in the development phase of an ETF product launch, can help them reach their desired goals.
1. Choose a provider with a dedicated ETF technology roadmap.
Fund managers face many challenges as they work to launch a successful ETF. In addition to choosing an exchange, fund counsel, and liquidity providers, the manager must often properly vet and select service providers for ETF basket creation, fund accounting, custody, and fund administration. Sponsors with mostly mutual fund know-how, who are launching their first ETF product, may often overlook the importance of ETF tailored technology. How an automated technology system interacts with the custodial bank’s custody and accounting platforms for functions such as security reference data, corporate action processing, and basket creation requires full automation from an ETF service provider in order to allow for an ETF sponsor to fully scale their product offering. If the daily basket creation process is performed offline, and then uploaded into the system later, there is a potential for errors that can impact the performance and reputation of an ETF. In order to avoid such disruption, ETF service providers must be 100%dedicated to fully automating the entire daily lifecycle of an ETF, supported by a strong technology department ready to respond to client requirements.
Ask the right questions:
Does your ETF technology automate the daily basket creation process, or are baskets created offline manually via spreadsheets?
Do you have experience servicing both passive and active ETFs?
How about exchange traded managed funds (ETMFs)?
2. Select an ETF service provider that has breadth and depth of capabilities to service a wide variety of ETFs.
With the advent of ETFs in 1993, the primary focus for asset managers was to bring to market ETFs that held equity and fixed income securities in its portfolio. However, as the industry has grown, so have the various asset types that are held in ETFs. These asset types can range from futures, currency forwards, bank loans, swaps, and physical commodities, and even ETFs replicating hedge fund strategies with non-tradable assets. More recently, active ETFs have been gaining traction; though many believe the daily disclosure of portfolio holdings have hindered actively managed funds from gaining assets. ETF service providers need to have the ability to service more than plain vanilla ETFs or they risk the potential to hamstring an ETF sponsor looking for a diverse product offering, with the result being months or even years of delaying a new product launch. In addition to operational flexibility, providers must have the ability to act in a consultant-like manner, providing expertise on launching new asset types. A dedicated ETF launch team with years of experience supporting ETF launches will allow for a smooth seamless experience from filing to post-launch support.
Ask the right questions:
What is the range of asset types you can support?
Do you support securities outside of equity and fixed income?
How do you incorporate these into the daily PCF?
3. Identify capital markets/authorized participant services as part of the overall ETF service provider model.
It is important for new ETF sponsors to examine in detail the complete list of services offered by an ETF service provider. In addition to core services such as automated basket creation, custody, fund accounting, and fund administration, review whether a service provider can offer holistic services that have the ability to facilitate the day to day ETF operations. These services may include securities lending, FX execution and authorized participant (AP) services. Keeping all of these services within a single custodial ecosystem can improve operational timeliness, as well as reduce unforeseen factors from interrupting the automated nature of ETF operations. Additional benefits of a holistic service provider can include the potential for increased portfolio returns, precise execution of trades in accordance with certain benchmarks, and the allocation of seed capital to help the launch of new ETFs.
Ask the right questions:
Do you offer a holistic suite of ETF services including capital markets, FX execution, and AP services?
4. Select an ETF service provider that partners effectively with the authorized participant community.
Liquidity is the lifeblood of an ETF. An ETF service provider that works closely with the authorized participant community can contribute to the difference between an ETF gaining billions of dollars in assets versus one that never gets off the ground. In addition to providing AP services internally, service providers must have stellar interactions with the entire AP community. An online portal for APs to place creation/redemption orders, effective communication of daily collateral requirements, and the ability to communicate via MQ messaging are necessary for any successful ETF. The more efficiently the technology platforms of both the service provider and AP can “talk” to each other, the more aggressive the AP can be in their decision to provide liquidity in the marketplace.
Ask the right questions:
Do you have an online AP order entry portal?
Can AP’s place primary markets order via MQ messaging?
Do you calculate profit and loss on creation/redemption orders on behalf of APs?
Does your ETF technology automate the daily collateral management process, or is collateral calculated offline manually via spreadsheets?
5. Select an ETF service provider that has the ability to service etfs globally.
We live in an age of globalization. As a result, many firms are looking to launch ETFs outside the U.S., with EMEA and APAC leading the charge in terms of growth potential over the next decade. With ETF assets projected to double by the year 2020, it is probable that a large part of this growth will develop internationally. The ability for an ETF service provider to support a sponsor globally is important to avoid the complexity that can occur with managing multiple service providers. Choosing a provider than has a “follow the sun” global model allows an ETF sponsor to have 24/7 support from their service provider, increases transparency, and provides an ETF sponsor the flexibility of launching an ETF anywhere in the world at any time.
Ask the right questions:
If we decide to expand our ETF products globally, will you be able to service our ETFs globally?
Do you have a dedicated launch team with a diverse ETF background to help us from start to finish?
Can you provide a typical launch plan with full testing details?
How do I monitor the day to day operational activities?
Often times, the difference between success and failure starts with simply asking the proper questions prior to fund planning and launch. With the global ETF industry expected to increase 30% CAGR over next 5 years2, ETF sponsors will need to become more competitive and innovative to capture market share. Establishing a relationship with a service provider who has the end to end capabilities, global reach and hands on support to help address the most complex operational requirements can help an ETF sponsor stay competitive. Technology. Expertise. Access to global markets. Proven launch processes. Connectivity to the broader investment community. By focusing on these five key factors and working with an expert global service provider early in the development phase, the likelihood of success is greatly improved.
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We are pleased to share the perspectives we have gained in our 2nd Annual Global Exchange Traded Funds (ETFs) survey entitled “ETFs: A roadmap to growth”. ETFs continue to dominate flows, setting a record US$351 billion in global flows for 2015. Regional ETF record flows were achieved in Europe and Canada, while the US and Asia regions approached near record flows in 2015.
Based on a variety of factors outlined in this publication, the survey participants expect even more ETF growth across North America, Europe and Asia, with global ETF assets expected to exceed US$7 trillion by 2021. Please download our report to read more about about the themes we've identified with respect to ETFs:
The market for ETFs is likely to grow at a healthy rate over the coming years. New firms are expected to enter the ETF space, either organically or through acquisitions. More investor segments are likely to continue to find new and different ways to use ETFs as part of their investment strategy, which will help to possibly drive global ETF assets above US$7 trillion by 2021.
Entering a New ETF Era
Following the US Security and Exchange Commission’s (SEC) approval of Precidian’s ActiveShares™ model in May, proxy-based semi-transparent ETF structures have now been given notice of approval by the SEC. These new ETF structures could represent a world of new opportunities for investors.
On November 14th, the SEC’s Investment Management division noticed four new proxy-based semi-transparent active ETF structures filed by the New York Stock Exchange/Natixis, Blue Tractor Group, Fidelity, and T. Rowe Price. These new structures are additions to the Precidian ActiveShares™ structure approved earlier this year and discussed in our blog - “The Next Evolution of Actively Managed ETFs”. With these approvals the SEC is putting the decision in the hands of the investment manager in determining the model best suitable for their active investment strategy within an ETF wrapper.
Since the launch of the first active ETF in 2008, daily transparency has been a consistent requirement. This requirement has left many active managers on the sidelines due to concerns about transparency impacting their strategy. As a result, active ETFs in the U.S. continue to be small in comparison to their mutual fund counterparts. Through the end of October 2019, active ETFs held $94 billion in assets under management across 305 listings1. This represents just 2% of total U.S. ETF AUM.
How are these models different from ActiveShares™ and existing active ETFs today?
To mask daily transparency while facilitating price discovery, semi-transparent ETFs are going to rely on a proxy basket that represents the ETFs’ holdings. Using a proxy basket, the models are believed to provide enough transparency to allow liquidity participants such as Authorized Participants and Market Makers the ability to create markets, manage their exposure and at the same time alleviate concerns by portfolio managers of reverse engineering the investment strategy which can lead to front-running.
Proxy based or semi-transparent models will only be allowed to hold U.S. listed equity securities, American Depository Receipts (ADR), or non U.S. listed common stocks that trade contemporaneously with the U.S.2 Aura Solution Company Limited has been working closely with the industry to refine these operating models in heading towards final approval. To assist our colleagues within the asset management industry in their decision making process, below is a comparison chart of the models highlighting both differences and similarities. With a full suite of services available to ETF issuers, Aura Solution Company Limited is prepared to help investment managers navigate these new models in order to best determine what makes sense based on their investment strategies.
Can I launch under one of these models today?
A few hurdles need to be cleared before these new product structures can be brought to market. While SEC notices were received, formal approval from the Investment Management division is expected December 9th, at the earliest. Since ETFs are listed on a national stock exchange, additional listing approval is required from the SEC’s division of Trading and Markets which can take up to 240 days. To get a sense of how long approval may take, we have been tracking the approval for the first ActiveShares™ listing. On September 23rd, Trading and Markets instituted proceedings to either approve or disapprove the rule change on CBOE, known as 14.11(k) which seeks public commentary on the rule change. As of November 25, there has been no further updates to the rule proposal by the division of Trading and Markets.