Sizing the ETF Opportunity: From Passive Revolution to Active Evolution

The U.S. asset management industry is in the middle innings of an underlying secular shift toward exchange-traded funds (ETFs). Over the longer term, we expect that traditional mutual funds (MFs) will cede much of their assets under management (AUM) not attached to defined-contribution retirement plans. Advantages of an exchange-traded wrapper, combined with longer-term demographic shifts, will be the ultimate driver of this phenomenon. However, the ETF passive revolution is mostly behind. From here, its evolution will be increasingly down an active path. MF conversions remain topical, but mostly around an offensive vs defensive rationale. The embedded infrastructure related to the advisory channel and its suppliers is an important factor.

Currently there is approximately $25.5 trillion in US mutual fund AUM. Ex– money market mutual Funds (MMMFs), the amount is closer to $19.5 trillion. This relates to $8.5 trillion in US-listed ETF AUM. We project that $6 trillion to $10 trillion of non-MMMF mutual fund assets represents a potential target for ETF replacement. Of course, this is predicated on current market price levels, so the total could be higher or lower over time as a function of equity and debt market returns.

We have hypothesized in our ETF work over the years that the MF industry is at structural risk to ETFs. But there are gating factors to this. One is related to the nature of retirement plans and their funding. The other pertains to share class structures. That is, where an ETF can be offered as a share class alternative to an existing MF, cannibalization is a lesser issue.

Further, our bigger-picture view has been and continues to be that ETF industry innovation is pushing away from passive index replication and down the active management path. We expect that most new product innovation will be developed around an ETF/exchange-traded wrapper rather than via MFs. Additionally, the past several years of ETF launch activity supports a view that most traditional asset managers will consider augmenting in-house “IP” or investment acumen via ETFs in a “wrapper agnostic” manner. Conversions, parallel funds, and newer stand-alone ETFs all fall within this. Increasingly, traditional asset managers are looking for opportunities to invest in private companies alongside public markets as one means of differentiation.

Somewhat related, we suggest that much of the passive tailwind in the decade following the Global Financial Crisis (GFC) can be attributed to benign economic growth where Fed monetary policy struggled to trigger economic activity intended to avert disinflation concerns. During that timeframe, the mega-cap growth cohort of US equities benefited from both outsized earnings growth and the positive valuation read-through from low interest rates. Going forward, higher-than-previous inflation and interest rates could set up for an improved active management opportunity. All told, the next wave of ETF growth should be aligned with an active management bias, thus supporting our contention that traditionally active MFs need to contend/compete/align with exchange-traded alternatives.