ETFs Are Disrupting Wealth Management

By Quentin Batista

Millennials are reshaping many aspects of American society. As this generation comes of age, their demands are evolving and doing so at a quick pace. An industry particularly impacted by this trend is wealth management, where exchange-traded funds (ETFs) are eating away at the market share of mutual funds, and now represent around 30% of the overall U.S. trading value by dollar.

According to a study from Charles Schwab, millennials are more likely to see ETFs as a core investment, allocating on average about 41% of their wealth in ETFs versus about 17% for the boomers generation.

However millennials aren’t the only ones driving this trend – everyone is onboard with ETFs. From 2012 to 2015, the proportion of ETFs in American ETF investors’ portfolios doubled and is expected to double again five years from now.

An ETF is a security that tracks an index such as the S&P 500, a commodity such as gold, bonds, or a basket of assets. It owns the underlying assets and divides ownership of those assets into shares which the investors buy.

One reason behind the growing popularity of ETFs is that they typically are much cheaper than traditional funds and management fees are a leading decision point, especially for younger generations. In fact, 87% of U.S. individual ETF investors say that commissions matter, and 41% of them consider commission-free ETFs to be “game-changers.”

As a sign of the changing times, Charles Schwab announced last week that it was cutting equity and ETF trading commissions by 22% from $8.95 to $6.95. Charles Schwab already offers free trades on a number of ETFs.

New Players

In response to these shifts, various “robo-advisor” companies providing online wealth management services such Betterment and Wealthfront have emerged. These companies leverage their technological capabilities to offer automated, algorithm-based portfolio management, frequent rebalancing, and financial advisory services as well as tax loss harvesting (see below).

Betterment, the leader in the space, has grown substantially since it was founded in 2008. Now has $7 billion under management and is valued at $700 million.

This is only the start. In fact, robo-advisors are forecasted to manage $2.2 trillion (around half of what BlackRock manages) by 2020.

Changes in Investing

ETFs are also reshaping how wealth can be managed. On the tax side, ETFs offer the ability to harvest tax deductions by realizing losses on investments that have declined in value while roughly maintaining the same position. This is made possible by buying a security with a high correlation to the original investment so that the new position trades roughly in line with the original one.

Not only can the tax savings be reinvested to generate additional return, this approach also allows investors to benefit from differentials between short and long term tax rates on capital gains.

ETFs are also allowing access to sophisticated investment strategies by commoditizing them. Financial securities are typically divided into asset classes: equities, bonds, commodities, and such. For each asset class, the portfolio theory offers multiple drivers of return, like style, size, and risk.

Many hedge funds have built investment strategies that take exposure to securities exhibiting factors that have historically generated excess returns. By tracking specific indices, “smart Beta” ETFs can replicate the strategies offered by these hedge funds at a fraction of the cost.

Industry Wide Results

These changes are having an impact on the way the industry operates. The fee structure of asset managers is coming under pressure: the typical 2-20 fee structure – 2% of the assets and 20% of the fund profits — charged by hedge funds is moving towards a 1-15 structure.

Hedge funds are also particularly exposed to this trend. These funds operate by identifying and investing in top performing alternative asset class funds and, accordingly, they charge additional fees on top of the ones charged by the hedge funds in which they invest.

As investors become more and more cost-conscious, they are particularly prone to avoid this type of structure, thus leading to an erosion of hedge funds’ dominance in asset management.

While these changes have been mostly limited to traditional wealth management for the time being, this is only in the short term. Over the long term, what has started with robo-advisors in wealth management such as Wealthfront and Betterment will likely spread to the rest of asset management financial services.

Platform Invasion and Market Dominance

The final stage of all the changes currently taking place in the wealth management industry is the rise of a platform business model disrupting the alternative asset class. The next step in this direction seems to be an investment platform to connect accredited investors and alternative investment managers. While ETFs can sometimes mimic sophisticated strategies, they are still an imperfect substitute for the strategies offered by hedge funds.

For example, even if some ETFs, like the one from PowerShares Global Listed Private Equity, can provide exposure to private equity deals, this is achieved by pooling together stocks of private equity investment firms such as Onex and is therefore not a direct exposure.

iCapital Network is a platform aiming to fill this gap. By leveraging its technological capabilities, the company aims to connect qualified investors with managers, and allow them to invest through the platform.

This innovative approach caught the eye of BlackRock, who recently led the startup’s most recent funding round in December 2016. Since it was founded in 2013, the company has accumulated a user base of investors worth $1.3 trillion and over 750 private equity managers.

Whether this company will become a modern monopoly remains yet to be determined. The economics of platform business models is that there are only ever two winners. As we have seen before with other platform companies, the first mover isn’t always the final victor.

iCapital has the opportunity to leverage its first mover advantage to become one of the two dominant players.  The second will either be a startup or an existing financial institution looking to capture its share of the trillions of dollars seeking investment in alternative asset classes.

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