What's Left to Be ETF'd? A Lot…

Market Demand Continues to Drive Growth

The ETF market thrives on investor demand, and the variety of products available reflects the needs of different investor types. Over the past year, we've seen new strategies emerge, such as ETFs incorporating options, swaps, futures, and combinations of these. Active management and long-short strategies also remain in demand. There is still untapped potential in converting capital from mutual funds and separately managed accounts (SMAs) to ETFs, providing a long runway for continued growth.

The Untapped Potential: SMAs and Mutual Funds

One significant area where ETFs have yet to fully penetrate is in the conversion of separately managed accounts (SMAs) and mutual funds. These traditional vehicles hold vast sums of capital, and the advantages of ETFs—chiefly tax efficiency and ease of trading—present a compelling case for future conversions. As these funds recognize the potential to be more tax-efficient and investor-friendly, I expect continued growth in ETF conversions, providing ample room for product expansion.

The Shifting Landscape: Dodd-Frank and PFOF

Since the Dodd-Frank Act and the rise of payment for order flow (PFOF), the competitive landscape has shifted. Smaller firms and boutique operations have struggled, leaving larger banks and firms to dominate the ETF space. These larger players hold more sway in determining which ETFs succeed. However, as long as there is a profit opportunity, market makers and authorized participants (APs) will step in to manage the risks involved in ETF creation and redemption.

The Importance of Relationships: Exchanges, Market Makers, and APs

Strong relationships within the ETF ecosystem are more critical than ever. This includes not just the partnerships with market makers and APs but also with exchanges themselves, which play a vital role in the growth of ETFs. Exchanges provide the trading infrastructure, liquidity, and visibility that help ETFs thrive. ETF capital markets experts play a pivotal role in maintaining and managing these essential relationships. They act as the liaison between issuers and market participants, ensuring that operational efficiencies are met and that the product functions smoothly across both primary and secondary markets.

Managing Margin, Hedging, and Capital Usage

As the number of ETFs grows, so does the complexity of managing these products. Market makers and APs are tasked not only with creating and redeeming ETF units but also with hedging and managing margin requirements across a broader spectrum of products. Each new ETF represents not just a single position but often a series of hedged positions that must be balanced in real-time. This significantly increases the size and complexity of the books these firms manage.

Capital markets experts not only manage relationships within the ecosystem but also provide valuable education to both issuers and investors on the intricacies of ETF operations, liquidity provisions, and market functions. As interest rates rise, the capital usage dynamics become more critical, with market makers and APs needing to allocate more capital to meet margin requirements. This evolving landscape emphasizes the need for a well-maintained and efficient ecosystem that incentivizes key players to continue providing liquidity and ensuring smooth market operations.

Ecosystem Investment is Key

ETF innovation isn’t slowing down, but the infrastructure supporting it must keep up. Market makers, APs, and exchanges need to be incentivized to support the growing complexity of ETF strategies. Success depends on continual investment in relationships and technology to ensure that ETFs remain liquid, efficient, and scalable.

Conclusion

The future of ETFs remains bright, with innovation continuing to drive the market forward. The number of ETFs will naturally be regulated by the market, and as long as investor demand persists and profits can be made, the ecosystem will continue to grow. The growth of ETFs relies not only on innovation and demand but also on the strategic management of relationships and capital within the ecosystem, where capital markets experts play a key role. Ensuring that the necessary relationships and infrastructure—including with exchanges—are in place is essential for this growth to continue.

About the Author

Nicholas Phillips | President of ETF Capital Markets Advisors LLC
With over 25 years of experience in ETF market making and capital markets, Nicholas Phillips is recognized as a subject matter expert in the ETF industry. He started his career spending the first ten years as a lead market maker for SIG and Goldman Sachs. At the helm of MCAP LLC's ETF Desk, Nicholas built and scaled the division, enhancing its operations through innovative pricing and risk models, and robust relationships with market makers and issuers. His tenure at Van Eck Associates as Director of ETF Capital Markets further solidified his expertise, managing critical facets of operations and deepening connections within the trading community. Beyond market making, Nicholas is an avid content creator, sharing insights that demystify complex market dynamics. He is keen on exploring board member roles that benefit from his extensive background and forward-thinking approach to ETF strategies. His dual US/Ireland citizenship complements his global perspective, enriching his professional endeavors in diverse markets.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.