• Exchange-traded funds could gain a further $US2 trillion to $US3 trillion in assets in the next three to five years, according to a report by Morgan Stanley and Oliver Wyman
• The rise of ETFs has put pressure on mutual fund fees, forcing many funds to cut costs
• In response, mutual funds are expected to invest heavily in ETFs to save money

A dramatic shift is underway in the investment world.

Passive investment products like exchange-traded funds have hoovered up assets at a fast clip in recent years. US-listed ETFs saw $US283 billion in net inflows during 2016, taking aggregate assets under management to $US2.5 trillion, according to Citigroup.

Exchange-traded funds could gain a further $US2 trillion to $US3 trillion in assets in the next three to five years, according to a big report on the future of the finance industry from Morgan Stanley and Oliver Wyman.

Fee pain is coming

ETFs are cheaper and more transparent than mutual funds, while mutual funds have struggled for performance in recent years. As such, money has poured out of mutual funds and into ETFs over the past few years. That has forced mutual funds to compress their fees so that they can compete.

With ETFs set to see their share in the US market increase from 15% to 40-60% over the next ten years, according to Credit Suisse, fee compression in the mutual fund industry will likely continue. Morgan Stanley estimates that fees charged by active managers could shrink by more than a third in 2017.

That’s not good news, because lower fees means less profit.

The irony

The price compression that has swept the mutual fund industry has forced money managers to come up with ideas to cut costs in order to save their bottom line. One such solution they have come up with is a bit ironic.

According to Morgan Stanley and Oliver Wyman, mutual funds are now using ETFs, the very funds that have contributed to price compression, to cut their own costs. By investing in ETFs, mutual funds are able to free up time to focus on “more complex alternative investments,” the report said.

Here’s Morgan Stanley and Oliver Wyman’s explanation (emphasis ours):

“Asset allocators such as Outsourced Chief Investment Officers (OCIO) and Wealth Managers will account for a large proportion of this incremental demand as they increasingly use ETFs at near zero cost to source beta exposure, allowing them to focus their resources on high conviction managers or more complex alternative investments. However, looking beyond 2019, the emerging use of passive vehicles as an integral part of an active fund management strategy will be arguably the more significant dynamic. Currently, Mutual Funds have ~$US0.5TN invested in ETFs, much of which is used for liquidity management. We estimate using ETFs rather than the traditional approach of holding individual stocks offers a cost advantage of 5-8 bps in large and mid-cap equities. As Asset Managers search for ways to deliver performance at lower costs, this may mean that mutual funds find themselves among the largest investors in ETFs.”

The report concludes that mutual funds will potentially be one of the biggest drivers of growth for ETFs.

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