Non-transparent exchange-traded funds (ETFs) are gaining product development mindshare, but whether they prove an attractive distribution opportunity remains to be seen—and is dependent on the products firms launch and the pricing strategies they pursue. According to new findings from Cerulli Associates’ U.S. Exchange-Traded Fund Markets 2019: Expanding Beyond Passive report, the majority (80%) of ETF issuers estimate that non-transparent ETFs will gather between $1 billion and $100 billion by 2025, suggesting that these products will take time to gain traction.
The U.S. ETF industry continues to expand, but while assets have been growing at a compound annual growth rate (CAGR) of 15% over the last five years through December 2018, industry revenues have only grown 11% annually over the same period. Intense competition, particularly amongst the most commoditized products, has made launching passive ETFs increasingly unattractive to all but the largest firms. ETF issuers polled by Cerulli in 2019 are significantly more likely to report at least moderate impact on their firm’s margins due to industry fee compression (46% report moderate impact in 2019 vs. 25% in 2018). As a result of both fee compression and product proliferation, ETF issuers are increasingly looking to develop more active products that can earn higher fee revenues. At the same time, traditional active managers are also interested in entering the ETF landscape (active mutual funds overall have suffered outflows since 2015), but the transparency of the ETF vehicle is a concern for equity managers that want to conceal their holdings to maintain strategy confidentiality.
Non-transparent ETF structures provide a solution for firms that want to offer active strategies in the ETF wrapper but not divulge holdings. According to Cerulli’s research, almost half of issuers state that they are currently developing (20%) or planning to develop (27%) non-transparent active ETF products, making for a momentous shift in a market where only approximately 2% of assets are currently actively managed—with some of largest asset managers either signing non-transparent structure licensing agreements or launching their own. “Nontransparent active ETFs are a logical progression as the existing ETF market moves beyond passive exposures,” comments Daniil Shapiro, associate director of product development at Cerulli Associates. “It’s likely that more active products will provide a more lucrative battleground for ETF sponsors, with the average issuer reporting that they expect to earn a greater share of fees from more active offerings in several years.”
Cerulli believes that non-transparent ETFs will gain traction, but that their adoption will be highly nuanced with product choice and pricing being the most significant challenges for asset managers to overcome. “Assuming that the non-transparent structures and associated infrastructure are found to be capable of supporting their strategies, asset managers will have to decide whether their newly launched products should be clones, differentiated versions, or entirely different products when compared to their existing offerings,” according to Shapiro. The decision will be impacted by concerns of over-saturating distribution partners and the cannibalization of existing products. “Asset managers will find it difficult to offer their best products at an attractive price—despite low costs being a key success tenet for ETFs—risking creating a self-fulfilling prophecy where launched products are slow to gain traction,” concludes Shapiro.