The ETF industry continues to evolve

A record year for ETFs

Last year was a notable one for the ETF industry in many ways. As 2023 drew to a close, both equity and fixed-income markets rallied, helping to push U.S.-listed ETF assets to a new record high of $8 trillion. While this number still pales in comparison to the nearly $25 trillion in mutual funds, ETF assets have doubled in less than five years and continue to gain market share from mutual funds.

Along with growing assets, ETFs also see continued innovation from issuers that are eager to adapt to investor’s shifting demands. There were 543 new ETFs launched in 2023, beating the prior record set in 2021 by over 60 funds. The vast majority of these products are actively managed, an expanding category in the ETF space that diverges from the vehicle’s genesis in index funds. Assets within actively managed ETFs have nearly tripled in the past three years, a trend that’s driven by lengthening track records and the vehicle’s reputation for tax efficiency

There’s still room for growth

Though the year has just begun, 2024 is shaping up to be another significant year for the ETF industry. On January 10, the SEC approved several spot Bitcoin ETFs, which began trading on January 11. This event, years in the making, highlights the pioneering nature of the industry and versatility of the wrapper, characteristics that should help to fuel continued growth and adoption.

Further supporting this idea, established mutual fund managers continue to enter the marketplace through mutual fund-to-ETF conversions or by launching ETFs that are the same or similar to already-offered mutual funds.

In addition, research shows that advisors currently allocate just over 20% of portfolio assets to ETFs but plan to increase this allocation to nearly 25% through the next year, continuing an upward trend that has been in place over the past decade.¹

Understand the risks

As active ETFs have gained traction with investors, some of the most popular ETFs over the past year have been more complex, including those that use options strategies to limit downside risk. This protection often comes in exchange for a cap on upside performance. Though the popularity of these downside mitigation ETFs is understandable given the equity market’s rough performance in 2022, the limitations of these products were in full display as equities rallied into the end of the year, ultimately rising to a double-digit gain. Many of these ETFs performed as expected in a risk-on market, lagging their respective benchmarks.

While we remain champions of active management, we believe that this example highlights the potential risks of trying to time the market. In our view, long-term investors would be better served by allocating the bulk of their portfolio to ETFs that can exhibit strong performance across the full market cycle.

Multifactor ETFs are one such option, offering exposure to several factors that have been linked to higher expected returns over the long term. While individually each factor might be in or out of favor at any given time, having diversified exposure to multiple factors can help to mitigate this risk and potentially reduce volatility.

For investors who do wish to take a more tactical view, ETFs can provide a simple way to gain targeted exposure to a specific sector, such as preferreds or mortgage-backed securities, that’s expected to do well in the market environment ahead. These funds can help provide further diversification within the portfolio while also offering the potential to outperform the broad market.

Using active ETFs to gain this focused exposure can provide an additional layer of risk management while allowing management teams the flexibility to take advantage of any market dislocations. Investors within these ETFs should be sure they understand the rationale behind these allocations along with any related risks.

Know what you own

As the ETF marketplace continues to grow and additional novel and complex strategies come to market, it becomes even more important for investors to know what they own, understand how the fund fits within the context of their overall portfolio, and recognize how these ETFs might be expected to perform across a variety of market environments. If you have questions about any of the ETFs within your portfolio, we recommend reaching out to your financial professional for more information.

1 “U.S. Exchange-Traded Fund Markets 2023,” Cerulli Associates, 2023.