ETF insights and strategies for financial professionals

ETFs: Coming of age

Fall 2017

Key takeaways:

  • We believe that the growth and size of ETFs do not leave the U.S. stock market vulnerable.
  • Low cost ETFs continue to grow in number and popularity, representing a disruptive industry trend.
  • Investors expect to raise their overall ETF allocations over the coming year, with millennials forecasted to lead the charge.
  • As ETFs' share of the investment landscape grows, a keen understanding of the ETF marketplace will be important for successful advisor practices.

The evolution of exchange-traded funds (ETFs) has been remarkable, and these versatile investments seem destined for continued robust growth. At Charles Schwab Investment Management, we have been encouraged to see the financial advisor community embrace ETFs and the many benefits that these vehicles offer. As a leading ETF provider, we are committed to helping advisors grow their businesses and further their ETF knowledge with expert insights and helpful tools. As such, we are pleased to share with you this inaugural edition of our quarterly ETF insights. In the following commentary, we offer perspective on the tremendous growth of ETFs, refute a widely held misconception associated with the rapid adoption of these vehicles, and provide insights from Schwab’s proprietary research.

ETF market share in proper perspective

From the creation of the first U.S. ETF in 1993, the market share of these investment vehicles has rapidly expanded, reflecting investors' growing appetite for buying and selling a wide variety of diversified investments as easily as buying and selling stocks. This expansion has given rise to questions and concerns by investors and the media alike, with the most common varieties focused around how the remarkable growth of the ETF market may be affecting U.S. equity valuations.

A closer look at relative market size is helpful to put these questions into proper context. Starting with the big numbers, the total aggregate assets under management for all U.S. mutual funds was $16.3 trillion as of the end of 2016.1 By comparison, assets under management were approximately $2.6 trillion for all U.S.-listed ETFs.2 Breaking down these figures even further, four clarifying points emerge:

— The U.S. equity mutual fund market remains much larger. The aggregate assets under management of U.S. equity ETFs are $1.7 trillion, a fraction of the size of the $8.5 trillion U.S. equity mutual fund market, even after nearly 25 years of ETF industry growth.3

— ETF inflows are not necessarily "new money." In recent years, funds have flowed out of actively managed mutual funds and into index-based mutual funds and ETFs.4

— The majority of ETF inflows in 2017 have NOT gone into U.S. equity ETFs. Year-to-date inflows have primarily targeted international opportunities, with 38% of the new capital flowing into developed and emerging market equity ETFs. Additionally, fixed income ETFs have garnered approximately 30% of the year-to-date inflows.5

— Year-to-date U.S. equity ETF inflows have represented approximately 32%—or $100 billion—of total ETF inflows.6 While $100 billion is a considerable amount, it is unlikely to have been the main driver of U.S. equity market valuations.

We believe that the growth and size of ETFs do not leave the U.S. stock market vulnerable, and that most concerns to the contrary are overblown.

With these points in mind, we believe that the growth and size of ETFs do not leave the U.S. stock market vulnerable, and that most concerns to the contrary are overblown.

ETF enthusiasm continues to grow

Historically speaking, advisors and wealth managers have fueled the growth of ETFs. However, more and more individual investors are realizing the benefits of these investment vehicles and are expecting to increase their future allocations. For the past seven years, Charles Schwab has conducted an annual ETF investor study designed to capture such trends, generating insights that the advisor community can leverage to increase the value of their client interactions while deepening connections and relationships. The recently released 2017 ETF Investor Study7 by Charles Schwab yielded numerous insights, including the following:

— ETF popularity continues to gain momentum. Overall ETF allocations among generations8 are on the rise, with 45% of investors surveyed planning to increase their ETF holdings over the coming year, compared with only 31% in 2015. Additionally, 42% of investors expect that ETFs will be their primary investment vehicle of choice in the future.

— ETFs factor into successful long-term financial planning. Investors increasingly believe that ETFs are an important investment vehicle to help them achieve their longer-term goals. At Charles Schwab Investment Management, we agree that ETFs should be viewed as long-term investments and not just as trading vehicles.

— Millennials are leading the generational wave. Millennials are roughly twice as likely to increase their ETF allocations over the coming year as baby boomers or the Silent Generation (a.k.a. “Matures,” the generational designation used in the 2017 ETF Investor Study).

Demand for additional ETF education

The 2017 ETF Investor Study also reveals the opportunity for more educational conversations with clients regarding ETFs. Part of any such conversation could be the traditional benefits generally associated with an ETF, such as making asset allocation readily accessible, low cost investing, and potential tax advantages. Your clients might also benefit from a discussion regarding the wide variety of ETFs, which include opportunities well beyond U.S. equities. Geographic regions, commodities, currencies, factor-based strategies, fixed income indexing and sectors, and smart beta represent a sample, with approximately 2,000 ETFs from which to choose in U.S.-listed vehicles alone.9

Leveling the ETF playing field

Another recent industry trend is the disruptive influence of low cost ETFs, which continue to grow in number and popularity. Over 50% of ETF inflows in 2017 have been into ETFs with operating expense ratios (OERs) of 11 basis points (0.11%) or less. What makes this fact striking is that only 134 ETFs—or approximately 7%—have these OERs, but they attracted more than half of all net flows for the first nine months of 2017. These investments are leveling the playing field, allowing advisors and investors of all sizes to employ asset allocation strategies that were historically available only to institutional or high-net-worth investors.10

Of our focused suite of ETFs, 14 of 22 carry OERs of 7 basis points or less, including some as low as 3 basis points.

At Charles Schwab Investment Management, we are dedicated to sharing the benefits of our scale and efficiencies to deliver low cost ETFs. Of our focused suite of ETFs, 14 of 22 carry OERs of 7 basis points (0.07%) or less, including some as low as 3 basis points. The Schwab 1000 Index® ETF (SCHK) is our latest low cost ETF, offering investors exposure to the 1,000 largest stocks in the U.S. equity market for just 5 basis points.

According to the 2017 ETF Investor Study, ETF investors "prioritize a low expense ratio and total cost above all else." At Charles Schwab Investment Management, we know that cost and simplicity matter. We are committed to providing a straightforward, focused suite of low cost ETFs for client portfolios, and to providing the advisor community with insights like this publication, enabling even deeper connections with clients.

ETF insights and strategies for financial professionals

Looking toward the horizon, we believe that the growing popularity of ETFs is a disruptive industry trend with self-sustaining momentum. Recent investor behavior and Schwab’s proprietary research suggest more incremental assets will be invested in ETFs in the years ahead, and that millennials—the largest living generation—will lead this charge into the future. If realized, this trend should lead to opportunities for advisors to connect with clients about the many benefits of ETFs. From inexpensive access to diversified market exposures, to low costs, to potential tax efficiencies over traditional mutual funds, a wide variety of conversational ETF entry points exist.

Moreover, as ETFs' share of the investment landscape grows, a keen understanding of the ETF marketplace will be an important factor for successful advisor practices. In future columns we will deliver insights and strategies that can be employed to help advisors create diversified portfolios and optimize long-term results. Varied investor needs and market environments create a wide range of opportunities for ETF usage. Yet no matter what the environment, diversified, low cost investing can contribute to long-term returns. At Charles Schwab Investment Management, we are committed to providing advisors the tools, resources, and investment solutions to help optimize their practices and client outcomes.

About the author

D.J. Tierney is a Client Portfolio Strategist supporting Charles Schwab Investment Management, Inc. (CSIM). In this role, he represents Schwab ETFs™ to sales channels, clients, and the media. He also works with CSIM’s product team to optimize Schwab's ETF offerings. Mr. Tierney assists in managing relationships and communications for Schwab ETFs with authorized participants, broker-dealers, and regulatory agencies. Prior to joining Schwab in December 2016, Mr. Tierney spent 16 years with Morgan Stanley as a senior institutional sales, trading, and relationship management professional. Mr. Tierney earned a Bachelor of Arts in Economics from the University of California, Los Angeles, and a Master of Business Administration from the University of California Berkeley’s Haas School of Business.

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