Here's the Next Big Thing That Will Disrupt ETFs and Your Practice

Mass customization is "the next $100 billion advisor opportunity," Matt Hougan, left, said at Inside ETFs with Dave Nadig. (Photo: Janet Levaux/ALM)

Inside ETFs Chairman Matt Hougan (above left) and ETF.com Managing Director Dave Nadig started their talk Monday on the state of the industry with one word: "Good!"

The industry, meeting now at the Inside ETFs conference near Miami, is raking in nearly $1 billion per day — or about $908 million.

"That's a lot of money," said Hogan. "It's a good time to be an issuer and an even better time for investor," given the low-cost portfolios available today.

How are things changing today and where is the industry heading? Get ready for a big journey toward direct indexing, according to Hougan and Nadig.

Industry Data

The two ETF insiders walked an audience of several thousand advisors and investors through the latest figures. In 2018, mutual funds lost $45 billion and ETFs gained $315 billion.

Since 2009, traditional mutual funds have seen outflows of $92 billion, while their exchange-traded counterparts have added $2.3 trillion.

"Things are changing among the top 10 asset gatherers, though," Nadig said. Last year, Goldman Sachs added $5.5 billion to its ETF flows, and JPMorgan brought in nearly $16 billion. "We underestimated this situation in our predictions [last year]."

In other words, he and Hougan did not believe that "the big banks would be so willing to cannibalize existing businesses so quickly," Nadig said.

As for when mutual fund assets may have hit their heyday, "We will call the peak … in 2017," he explained, when these products had about $16 trillion.

Future Shock for ETFs

According to Hougan, "ETFs are primed for disruption."

As is the natural evolution of all industries, exchange-traded products will meet the "next thing," as CDs did with the introduction of the iPod, for instance. "There is no end of history — just look at today's phones."

In the fund world, the evolution has gone from closed-end products to open-end mutual funds to ETFs.

"Like other technology, this is not the end of the story. We are not at the end of fund evolution," Hougan said.

For Nadig, to get to and through retirement, clients need a new mode of transportation. "ETFs are pretty good transport — tax-efficient, low costs, etc. — but they aren't perfect. They are not tax maximized, trading is not always good as the late John Bogle has said, … and we have 2,000 one-sizers fit all."

For clients to have their personal values and circumstances fully considered, a new product could be more helpful. Nadig and Hougan refer to this development as direct indexing, aka a portfolio that's "just for you."

Thanks to technology, brokerage commissions have fallen, share fractionalization abounds, and cloud computing makes optimization easy and cheap.

Since investors do not need brand names, marketing budgets, distribution networks and related services, they are looking to new products.

"We call it the great unwrapping," said Hougan. "Its for those who want to own securities without doing so within funds."

Direct indexing has been "around for a while," he added. It's meant to give investors "their own personal index within a certain band of tolerance."

It can replicate broad market indexes with a customized approach for each investor. And it can include lots of tax-loss harvesting.

Firms already doing it include Wealthfront, Prive, Optimal Asset Management, Eaton Vance-owned Parametric and Aperio.

Parametric has about $100 billion of assets in this vehicle, while Aperio has nearly $27 billion.

"If Parametric was an ETF issuer, it would be the sixth-largest and the fourth-fastest growing today," said Hougan. "This is not just pointed-headed stuff that we are talking about today … and very few people are paying attention to it."

Hougan reminded the audience that five years ago he and Nadig predicted that robo-advisor Wealthfront could be a big deal. "We saw the trend coming," he said.

Personalization matters, he explained, because investors care about specific issues, such as board diversity or stem cell research. "Let's fine-tune porfolios," Hougan said.

As mass customization has happened in computer, shoes and other retail areas, it can happen now in portfolios, according to Nadig. "It's not complicated."

For advisors, this means new conversations about clients' risk appetite and what matters to them. "What companies do you want to avoid? Like, have you had it with Facebook, or do you think Elon Musk is insane? What is unique about you?"

Hougan says advisors can win big with direct indexing. "We do not see ETFs going away," he said. But direct indexing can be a way for advisors to move beyond the current competition with platforms offered directly to investors by Vanguard, Schwab, Wealthfront and others.

"This is the next $100 billion advisor opportunity," he concluded.

Nadig says we won't see this transformation of the industry tomorrow. So there's time for advisors to ask how they can fit direct indexing into clients' investing journeys.

— Check out Ric Edelman's List of Industries at Risk on ThinkAdvisor.