The ETF industry started 2024 in a very strong position as it continues remarkable growth over the last decade, with monthly net inflows every month for almost five years. Strong market performance at the end of 2023 saw the industry hit record highs in assets under management (AUM) in each of the regions, with over $11.63 trillion invested in ETFs globally, doubling in the four years since the beginning of 2020.

2023 continued with the market turbulence we became familiar with in the 2020s. Central banks worldwide continued to tighten monetary policy to tame inflation, leading to recession concerns. A liquidity crisis within the banking sector led to the collapse of three mid-sized banks in the US and the takeover of Credit Suisse by UBS, all against a backdrop of escalating geopolitical conflict.

This caused markets to experience periods of sharp volatility while finishing the year with strong gains. Against this backdrop, continued inflows month-on-month combined with a strong market performance fuelled assets invested in ETFs to new heights.
The growth rate in this market segment continues to exceed expectations, and we expect assets in the industry to hit $25 trillion in 2030.

Is retail adoption ready for take-off?
With a population of almost 500 million people in the EU and the UK, there is a huge opportunity for growth for providers who can target the retail investor market in Europe. However, this is a much tougher market to penetrate.

In 2023, the EU Commission launched its retail investment strategy as part of its capital markets union initiative to encourage retail investors to participate in financial markets. The European Fund and Asset Management Association’s (EFAMA) December 2023 Asset Management Report highlights that 30% of assets in all funds managed in Europe were attributable to retail investors.

There are several initiatives directly empowering retail investors to adopt ETFs:
Savings plans in Germany have been very successful, with similar offerings being introduced across Europe. Across 2022 and 2023, several other countries across continental Europe have begun launching ETF savings plans, most notably Italy, Spain, France and Austria. Research conducted by extra ETF expects this to grow to EUR650 billion by 2028.

ETF providers are also partnering with online platforms or making acquisitions, for example JP Morgan’s acquisition of Nutmeg to target direct distribution to retail investors.

Active ETFs continue to gain momentum but are we at a tipping point for the industry?
After years of promise in the active ETF space, the market began to accelerate in 2020 and has grown 250% since then. Ending 2023 with $700 billion in assets under management, it now represents over 6% of the global ETF market.

Providers in the US have been driving this growth, with 2023 considered a tipping point, as most ETF launches during the year were in the active space. A combination of factors is powering the meteoric rise of active ETFs in the US over traditional mutual funds, most notably the inherent tax benefits of ETFs, more efficient cost structures and increased tradability.

Historically, ETFs have been synonymous with passive products, but the increased popularity of active ETFs has seen managers eager to test the active ETF market. Large numbers of US managers have launched new products, with a steady flow of managers converting their traditional mutual funds. These include JP Morgan and Fidelity, which are converting large swathes of assets in their traditional mutual funds into ETFs.

In 2020, the first wave of semi-transparent ETFs was launched, as the structure was authorized by the SEC when transparency was a key concern for managers. However, these concerns appear to be receding. In 2023, less than 2% of the assets invested in active ETFs are in semi-transparent structures.

Barriers to entry to the ETF market are rapidly falling, with a proliferation of white-label platforms leading active managers to launch their first ETFs. Some of these are looking at ETFs as a core part of their current offering, while others are looking to future-proof their business to have a track record in ETFs for when they need to expand their offering.

Over the last 10 years, we have seen ETFs’ share of the global regulated open-ended funds grow from under 7% in 2013 to over 15% in 2022, demonstrating that greater shares of flows are being actively directed toward ETFs each year, most notably in the US. Although this may reinforce the argument that ETFs could cannibalize mutual funds, it does demonstrate that traditional mutual funds are losing market share to ETFs.

Following the momentum in active ETFs in the US, many are looking to Europe. Uptake has been slower than in the US, with many suggesting no demand for active ETFs in Europe. However, it’s becoming increasingly evident that lack of supply is the issue in Europe. As managers have become comfortable with transparency, many US managers are looking to Europe as a new growth avenue.

HSBC has been innovative with their entry into the ETF market in Europe, launching exchange-traded share classes from its existing global fixed-income index fund. This could be a viable entry path for managers but there could be regulatory and taxation hurdles with this approach.

There are however providers with plans to launch imminently:
• Cathie Wood’s Ark Invest recently acquired Rize ETFs as a move to enter Europe.
• Dutch provider Robeco hired experienced ETF veterans, showing intent to enter the active ETF market in 2024.
• White-label platforms have reported increasing interest in active ETFs.

AI and its impact on the ETF industry
In fund management, with its ability to analyse vast amounts of information from various sources, AI can help identify patterns and trends to distil investment research and assist portfolio managers in making more informed investment decisions.

AI is now being integrated across the value chain enabling smarter decision-making and risk management in managing model portfolios. Investor interest has also been piqued in the ETF world, with the launch of a few AI-powered ETFs like WisdomTree International AI Enhanced Value Fund and VanEck Social Sentiment ETF. They have machine learning algorithms trained on large quantities of historical market data to quickly identify market patterns and make investment decisions.

AI-powered ETFs have the potential benefit of identifying and reacting quicker to market events than human managers in active ETFs and being more flexible than in index-tracking ETFs.

However, investor uptake still needs to be seen. With market volatility and a diverse investor base, there are nuances required in portfolio management that machine learning can only bring to a certain point.

A maturing approach to ESG
In Europe, ESG investing has been a strong growth driver, with record inflows from 2020 to 2022. In 2022, over 55% of all inflows into European ETFs were into Sustainable Finance Disclosure Regulation (SFDR) Article 8 and 9 funds.

Flows into ESG ETFs in 2023 have tempered, with just under 25% of this year’s ETF inflows directed into these products. While the segment’s overall European ETF market share is growing, lately it has received less media attention.

Several factors have weighed on the wider ESG fund market:
• Higher market volatility and interest rate environment causing a flight to safer asset classes, such as government bonds, where it is more difficult to apply ESG strategies.
• Poor performance of the markets these funds typically invest in (e.g., renewable energy).
• Poor quality of data on ESG factors from underlying companies.
• Investor confusion between classification regimes for different jurisdictions.
• Investors’ malaise and political backlash at the sector in certain regions of the world.

These factors have sparked outflows from the wider ESG fund market, particularly in the US. However, it is still a strong long-term investment theme, particularly with European investors. The EU has been introducing various measures to encourage retail investor participation in the green transition, and we expect ESG-focused ETFs to be part of this.

Tokenization: Is this the next evolution of the ETF?
We are seeing financial market participants increasingly interested in digital assets and tokenization.

Physically backed digital asset exchange-traded products (ETPs) have been on European markets for several years from providers such as 21Shares and ETC Group, which allowed market participants to trade this asset class on exchange in Europe, although subject to certain restrictions in terms of distribution. In January 2024, the SEC also approved applications for 11 spot bitcoin ETFs filed by firms such as Fidelity and Invesco.

This approval fundamentally changes this industry segment from one that was unregulated, operating from Europe with under $13 billion at the end of November 2023, to one that is mainly regulated, operating from the US with almost $53 billion, at the end of January 2024.

Although the EU Commission is currently undergoing a wide range review of the Undertakings for Collective Investment in Transferable Securities (UCITS) eligible assets directive, which potentially may open the door for digital assets in the future, diversification requirements under UCITS would see single exposure products (such as the spot bitcoin ETFs approved by the SEC) remain as ETPs in Europe, similar to commodity products and single exposure stock products.

Nevertheless, the SEC approval of these products is fundamental and will see a wider adoption of digital assets across mainstream financial market participants, certainly galvanizing what comes next for the industry. It remains to be seen if this is the approval of another on-trend product type or another step toward tokenization across the asset management industry.

Tokenization could be the next step if the industry is looking to speed up the cycle further and offer a solution for ‘real-time’ settlement. The wider asset manager industry is looking at tokenization to increase the efficiency and liquidity of trading in alternative assets (such as private equity or fixed income) and unlock new sources of capital.

Some providers have been looking at pilot projects to tokenize the issuance of funds and to work through the commercial, legal, and technological challenges before they explore expanding this. The FCA in the UK has announced they are working with the industry, with the Investment Association in the UK recently publishing a blueprint for tokenization implementation across the space.

Tokenization has the potential to fundamentally change the asset management ecosystem. It could improve the speed of settlement and open up new avenues for investors.