ETFs have evolved in the past decade to become one of retail and institutional investors’ preferred investment vehicles. The reasons are various, but the fundamental one is the ease of gaining exposure to diversified investment strategies, including various asset classes, indices, factor-based approaches, or even leveraged products. Nowadays, there seems to be an ETF tracking just about anything. ETFs are a subcategory of exchange-traded products (ETP), which also include exchange-traded notes (ETN) and exchange-traded commodities (ETC). The main distinction is that ETFs tend to be secured, owning a basket of assets in segregated accounts to minimise the risk of default.

Globally, total assets under management within ETF structures lie slightly above USD10tn, with the majority of the products issued in the US, and even a higher proportion holding US domestic assets. What is important is that the percentage of assets in ETFs as a percentage of total fund assets (ETFs plus mutual funds) has changed from 15% to 34% in the past decade. Dissecting for equities, the change is from 19% to 36%, and most striking of all, for fixed income, the change is from 9% to more than 27%. 

Given the ease of access and the advantages in terms of liquidity and costs, many investors are opting for ETF exposure instead of traditional mutual funds, with many mutual funds converting into ETFs. Liquidity has reached a point where some ETFs are even more liquid than some of the equities they encompass. Passive mutual funds and ETFs have certainly grown in terms of their AuM, but even more interesting is the fact that ETFs are often the marginal buyers of the index constituents, which has led to the average US S&P 500 stock having around 19% of their shares owned by these passive funds. Proportions vary strongly across thematic leaders. When new companies are listed in the S&P 500 index, the ETFs have the need to rebalance their holdings and allocate to these new companies, that will strongly benefit from the higher share demand.

The great diatribe: Active vs passive?

The most interesting debate arises from the competition between active and passive ETFs. As passive ETFs have gathered billions in assets over the past couple of years, the vehicles have been commoditised and the levels of differentiation are next to none. Active ETFs are poised for further growth, in-line with exotic or specialised structures. Even though active ETFs have only picked up recently and represent only 9% of total ETF assets, they are driving outsized growth. They have accounted for 30% of flows in 2024 and generated 72% of the industry’s fee revenue.

Going forward, expectations on a changing regulatory backdrop, including the potential expansion of ETF share classes for mutual funds, is set to drive the number of active ETFs on the market. Since 2019, most product launches have been actively managed leading to more than 1300 products or near 60% of the almost 2000 total products entering the market. The number of indexed offerings has largely decreased. The active share is only set to grow, as issuers do not have to pay the often-expensive licensing fees to index providers and can also charge higher management fees, even if the active component only takes the form of factor rotation, from a momentum to a value strategy.

Market mechanics: Who benefits from the surge?

The ETF industry operates through a highly interconnected ecosystem involving asset managers, index providers, market makers, and exchanges. 

• Asset managers dominate the market by leveraging economies of scale and brand loyalty to maintain cost leadership and create high barriers to entry. The top 3 asset managers control 75% of the ETF assets.
• Index providers play a pivotal role by licensing benchmarks, with their revenue models tied directly to their asset gathering practices. These firms have outperformed the broader market over the last decade, reflecting the growing importance of index-linked products in the investment landscape and the scalability of their business model.
• Market makers are critical to the operational side of ETFs. They facilitate liquidity through the creation and redemption mechanism, ensuring that ETF prices closely track their net asset values (NAVs). This process, which depends on authorised participants, enables ETFs to maintain tight spreads and robust secondary market activity.
• The largest authorised participants are in fact private companies. Every single tranche of the process is controlled by a handful of players, which could eventually lead to a certain degree of systemic risk.
• Exchanges or secondary markets are also profiting from the surge; as the demand these wrappers are generating translates into exchange volume, so are financial information providers and trading infrastructure providers. The implications are multifaceted.
• Brokers have also had increased volumes from this growing category, where they can certainly profit from the trading volumes and the more complex underlying these wrappers are replicating, and the rise of AuM for big platforms only add to the equation. Custodian banks also play a key role.

The companies operating in the space are benefiting from high market entry barriers and are exhibiting unparalleled economies of scale. They have demonstrated a constant ability to innovate, structurally shaping the way we invest, and they will likely continue to drive disruption. ‘The times they are a-changin’, as Bob Dylan once proclaimed – this could not be more accurate for the ETF industry.

ETFs are set to continue disrupting the status quo

ETFs have transformed financial global markets, offering investors unprecedented access to diversified, cost-effective, and liquid portfolios. As the industry continues to evolve, the balance between active and passive strategies, the rise of thematic and leveraged products, and the adoption of new technologies will shape its future trajectory. These developments underscore the centrality of ETFs in modern finance, ensuring their relevance in an increasingly complex and dynamic investment landscape.

Altogether the structural growth of the ETF segment is set to persist, providing a compelling backdrop for the companies along the value chain. Adding in the administration change in the United States, we expect more market-friendly regulation for our ‘Future of Finance’ theme more broadly, prompting us to upgrade our rating to Constructive.