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Live digital or die The digital challenges that ETF sponsors and service providers must confront

PwC | Live digital or die

Contents

Executive summary ........................................................................................................................ 1

Breakdown of the ETF market ....................................................................................................... 3

Impact of digital technologies – Operations ............................................................................... 5

Impact of digital technologies – Distribution .............................................................................. 6

Mass customization ........................................................................................................................ 8

Impact of digital technologies – Products ................................................................................. 10

Conclusion ..................................................................................................................................... 12

PwC | Live digital or die 1

Executive summary Exchange Traded Funds (ETFs) continue to experience significant growth and innovation. We expect that continued advances in digital technologies will significantly impact ETF sponsors, service providers and other participants.

We foresee technological change driving significant impacts upon ETF operations, distribution and products. These changes will also impact a firm’s profit margins, regulatory risks, cyber security, and customer interactions. There is no question that successful firms will need to evolve rapidly to keep ahead of their competition.

This paper leverages the results of our ETF global survey and includes our insights on how the ETF industry will be impacted by FinTech over the next few years.

About the survey

PwC surveyed executives from approximately 60 firms around the world in 2016 using a combination of structured questionnaires and in-depth interviews. More than two-thirds of the participants were ETF managers or sponsors, with the remaining participants divided between asset managers not currently offering ETFs and service providers. Participating firms account for more than 80% of global ETF assets.


Digital technologies are fundamentally reshaping the operations and economics of the ETF industry and our view is that the trends we see today will accelerate in pace and impact. This will create what might be euphemistically termed a “challenging environment” for those firms that resist exploring, and adopting technologies such as automated advice, artificial intelligence, blockchain, big data, machine learning and the rest.


Breakdown of the ETF market

It's important to set out how we see the so-called “ETF market” because in fact there is no such thing. It’s a little more complex, as we see three distinct and separate markets for ETFs, each with different dynamics and competitive forces. Each of these markets will be impacted by digital changes, but in different ways.

Market 1 – Index replication – What we refer to as ‘plain vanilla’,

these products have attracted sizable assets and saved investors significant amounts since the very dawn of the ETF industry. Investors are looking to replicate as closely as possible, the return on an index. There are several large

players with extremely large funds tracking the well-known indexes at extremely competitive fees. This is a scale play and largely a commoditized business.

Fees might be extremely competitive today but they are likely to become more competitive in the future, by definition as in economic terms in a commoditized market fees gravitate towards the intersection of the marginal revenue and marginal cost curves.

Here the principle impact of digital technologies will be upon operations – to remain in this market ETF sponsors will need to be efficient and able to compete on price.

Market 2 – Smart beta – There has been a lengthy and well documented

series of commentaries around the naming of this category and also its exact definition. We will avoid repeating this and adopt the following broad definition of including all funds that follow an index that is something other than ‘market capitalization’. In reality, ‘Smart Beta’ is a broad continuum as detailed below. On the right of the continuum there is more complexity, more judgement, more scope for variation and we believe some protection from the chill winds of comparability that erode fees over time.

Figure 1: Smart Beta Continuum


To succeed in this smart beta arena you need at least one of the following competencies:

i. The capability to innovate – assets flow to innovative products – even from less well known organizations. Digital technologies are a source of product innovation, and provide new distribution opportunities.

ii. The capability to copy others quickly and remain profitable at lower fee levels – identify innovative products gaining traction and replicate with a lower fee. Capability in digital technologies may be required to emulate others in providing products and/or to gain access to consumers via new distribution channels, digital operations allow for enhanced profitability even at lower fees.

1 Strategic Insight: Simfund

Innovation is still rewarded in the smart beta space but the ‘innovation premium’ should be expected to decay faster in the future as competitors get better and faster at “replicating” strategies gaining traction in the market.

Market 3 – “Real Active” – The active ETF market has been around

since 2008, however, it has not taken off largely due to regulatory requirements to provide daily transparency of active portfolios, putting ETFs at a disadvantage relative to other products. The key issue is the front running of strategies and giving away the investment manager’s ‘secret sauce’. There are some products in this space but they are primarily fixed income where these challenges are less of a concern -

and we expect that assets in this class of products will continue to increase. Given that approximately 75% of all assets1 are in active strategies there remains scope for tremendous growth. Digital Technologies will drive this growth primarily through new and differentiated products aided and abetted by potential changes in distribution.

We will take the impact of digital technologies on operations, distribution and investment products in turn. We have titled this paper “Live Digital or Die” as we believe that in order to compete and thrive in any of the “ETF markets” set out above it will be necessary for organizations to effectively apply digital technologies whilst those that fail will ultimately exit the market.


Impact of digital

technologies – Operations

Almost every familiar aspect of the ETF industry is likely to be made over by the unprecedented onslaught of automation in the future.

Earlier this year, PwC surveyed asset managers, service providers and other industry participants around the world in order to get a better understanding of how they believe technology advances will impact the ETF industry. Among our survey respondents, 35% expect that the investment advisor operations function will be the most disrupted by the technological shift, as ever-expanding advances in data analytics and machine learning enable computers to sift through more information faster, resulting in more precise decision-making. Transformational developments in areas like artificial intelligence and machine learning can enable asset managers to build systems that outperform humans by mining complex financial data in a faster and more insightful manner.

2 “Managing millennial money.” PwC. http://www.pwc.com/us/en/financial-services/publications/managing-millennial-money.html

Brokerage services are also susceptible to having their business models dismantled, according to 29% of survey respondents. The growing sophistication of automated advice will likely boost their appeal to mass affluent investors. Successful investment firms will need to continue to expand their service offerings to meet client needs, including members of the millennial generation (ages 18 to 34) and Generation X, who are expected to receive $30 trillion in wealth transfers in North America over the next few decades.2

ETFs drive transparency and comparability especially in the plain vanilla index replication market. Market participants compete principally on price making efficient operations crucial. We agree with the survey respondents that digital technologies are and will continue to drive significant efficiencies in asset management operations.

Figure 2: Which part of the ETF industry is likely to be impacted by FinTech over the next 5 years?

Source: PwC 2016 Global ETF Survey

Investment

Operations

35%

Market

operations

and exchange

14%

Brokerage

Services

29%

ETF

operations

13%

Capital

markets

9%

http://www.pwc.com/us/en/financial-services/publications/managing-millennial-money.html


Impact of digital technologies –

Distribution

It's sometimes said that ‘beggars can’t be choosers’. The power in the ETF distribution chain may be disrupted by advances in digital technologies. Will your organization be a beggar or a chooser?

Automated advice platforms, which provide online investment advice using algorithms with varying degrees of human interaction, are an increasingly important source driving ETF assets from retail investors (who make up approximately 89% of mutual fund assets in the US market)3. Low-cost automated

advisors will continue their mechanized march through the ETF industry over the next few years, luring investors by dangling dispassionate model portfolios in their direction.

Currently automated advice platforms manage AUM of approximately $75 billion, according to ETF.com.4 How many

additional investment dollars will this technology drive in the next five years? Among PwC’s survey participants, 43% expect automated advice platforms to generate more than $50 billion of new flows for ETFs in five years.

About a third, 32%, expect automated advice to generate between $10 and $25 billion of new flows for ETFs while 25% expect that number to be between $25 and $50 billion. (See figure 2).

Compared to other geographic regions, US survey participants were more optimistic, predicting greater than $50 billion in new flows over the next five years related to automated advice platforms. By contrast, much smaller proportions of the European ETF market (37%) and the Asia and Oceania ETF markets (30%) are expecting new ETF flows on that scale.

We believe that these numbers are far too low and that growth will likely dramatically accelerate as the cost benefits and ability to provide consistent advice in a retail investor friendly format drive adoption. If the same level of growth noted over 2015 -2016 were repeated over the next five years automated advice AUM would amount to $811bn.

3 2016 ICI Investment Company Fact Book 4 “A Tour of the Top 10 Robos” ETF.com. January 24, 2017 http://www.etf.com/publications/etfr/tour-top-10-robos

Figure 3: What level of ETF AUM do you predict automated advice platforms will have in five years?


$10B to $25 B

32%

Greater than

$100 B

$25 B to $50 B

25%

$50 B to $100 B

23%

20%

http://www.etf.com/publications/etfr/tour-top-10-robos


We believe that automated advice platforms favor large incumbent asset managers. Yes, new entrants into the automated advice market have strong visualization, apps and websites but there is little proprietary technology protecting the independent first movers that can’t be bettered or replicated by incumbent organizations who also have the ability to buy this technology. However, we view the underlying technology as being here to stay (in fact, we expect rapid advancement). So is this the end of the story - incumbent asset managers developing and improving automated advice and driving ETF assets as a result? We believe there may be a second act, and the winners are as yet undecided.

We have lived in a world where ‘disintermediation’ has been not only a business school mantra but the route to a successful distribution strategy, whereby organizations are able to deal directly with investors and ‘cut out the middleman’. We believe that digital technologies can turn this logic on its head and drive a trend to ‘intermediation’. Consider ride sharing services, short-term house/room rentals, peer-to-peer lenders and others - these organizations herald a new age of ‘intermediation’ – with power resting with the owners of the platforms favored by consumers. Could we see similar middlemen in the asset management space? We explain more on the following page what this might look like in practical terms. Ownership of a smartphone-based popular application (or “app”) will be the goal, so is this a nut that will cracked by asset management incumbents? The future is unwritten and we will have to wait and see, but winners of the future may be different from winners of the past - in fact they may be companies not yet in existence.


Mass customization

Currently it is costly to have a truly bespoke investment portfolio tailored for your specific needs. Automated advice platforms have made a start in bringing mass customization to the market, but they are in the early stages. In our view, digital technologies allow for the potential of a new era of truly mass customization.

Mass customization is a trend in many industries, with examples such as sneakers and automobiles; so what could this look like in the asset management industry? Imagine an application (“app”) on your smartphone. The app leverages artificial intelligence to properly identify your investment objectives, personal circumstances and beliefs to construct a portfolio tailored just for you.

Your portfolio is dynamically reallocated based upon external events and changes in your circumstances, not just the march of time currently factored into today's ‘target date funds.’ ETFs would be a good investment option for such a portfolio given that they offer low cost access to equity, fixed income, commodity and other markets. Of course, further advances in technology are needed and regulators will likely want to examine such moves carefully, but compare this experience to a product made specifically for you versus a fund constructed to have mass appeal with no scope for fine tuning.

If adopted by investors, this model would change industry dynamics. Investors would likely care little about the asset management organization providing the underlying ‘building blocks.’ Instead, the brand and market power would be resident with the app on their smartphone.


Managing a portfolio of threats

Automated advice and other digital

technologies endanger entrenched

members of the ETF industry who

resist change. Successful ETF firms

will need to embrace the fast-

paced technology advances and

either invest in or partner with

technology firms to respond to

customer demands for low-cost

investment products and

innovative services.

Recognizing the main threat to the ETF industry, however, isn’t difficult. When respondents identified the biggest FinTech-related hazard, they didn’t choose pressure on margins, increasing regulatory risks or even information security threats. Instead, they chose each of those areas as potential FinTech threats for the ETF industry. (See figure 3)

Around one quarter of respondents selected each of those threats,

ranging from margin pressure (28%) to regulatory risks (27%) to information security/privacy threats (23%). In other words, firms in the ETF industry know what they must do—and keep doing—to remain competitive. Some, of course, have already embarked on their plans. Those firms have begun to separate themselves from their competitors by implementing digital solutions, including automated advice capabilities to penetrate new distribution channels. Through diligently applying technology, they have found ways to operate more efficiently and cost effectively. Next, they will need ways to keep innovating, to use FinTech—either their own, or that of a partner’s—to develop next-generation ETF services. To thrive in a reconfigured industry, they will need to reinvent themselves. And if they do it right, they’ll never be finished.

Figure 3: In your opinion, what are the potential threats related to the rise of FinTech within the ETF industry?


Pressure

on margins

28%

Increase in

customer

turnover

14%

Increase in

regulatory risk

27%

Information

security/

privacy threat

23%

Lost

market share

8%


Impact of digital

technologies – Products

ETFs have been at the forefront of innovation in the asset management industry recently (case in point - “Smart Beta”). We expect this to continue as digital technologies will provide new product opportunities and threats to those slow to adopt.

When asked, 28% of survey respondents noted that cost reduction had the highest impact related to advances in technology. (See figure 4) However, 23% identified differentiation, and a further 21% suggested the potential for increases in market share related to the rise of FinTech within the ETF industry.

Figure 4: In your opinion, what are the opportunities related to the rise of FinTech within the ETF industry?


We agree that digital technologies provide significant opportunities, but also pose as a threat with respect to investment product differentiation. Clearly product differentiation is relevant to the active ETF space and we foresee the rise of what we term “active 2.0.”

Diffentiation

23%

Increase in

market share

21%

Cost reduction

28%

Improved

retention

of customer

15%

Additional

revenue

12%


Artificial Intelligence (“AI”)

The cost and power of artificial intelligence and the computer processing to make it happen is constantly improving - and improving on an exponential not an incremental basis. In fact, it is likely that AI will be better and cheaper even by next year than it is currently. Why do we care in particular about this? In reality, artificial intelligence is complex mathematics tasked with solving. Asset management is largely based on ‘prediction.’

With predicative technology that is getting exponentially cheaper and better, we expect that three things will happen as a result:

1. More problems will be recast as predictive problems.

2. Predictions historically made by humans will increasingly be made by computers.

3. Use of prediction will increase.

In practical terms, what does this mean? One example is we expect to see active strategies that rely on publicly available SEC filings and filters over the S&P 500 to be automated. Computers will also absorb and correlate massive amounts of data to create an infinite number of strategies and back test the performance to find the most profitable outcompeting humans. We believe you will see many of these strategies in ETFs, and more.

Active 2.0

We see a bifurcation in active strategies driven by digital technologies. Exponential advances in computing power (particularly the cost and capability of cloud computing), predictive analytics, artificial intelligence and the ability to gather combined with increases in sources of ‘big data’ make it critical that organizations consider how to generate information from data.

There is an ever-increasing amount of ‘data’ in existence. We don’t expect this trend to slow down - in fact we expect the opposite. Increasingly this data is obtainable. Asset managers that have access to the largest data sets and the computing power to process, identify correlations and back test investment strategies will harness the power of these trends to generate alpha. Compare this approach to the organization using humans to pick stocks - this is a task inherently suited to computers and an inflection point will be reached, at some point, where humans are pushed out of this market - given that the results of active strategies are known, comparable and of keen focus for investors. A swift migration to ‘digitally enabled’ advisors should be expected after the inflection. Having a high performing algorithm and mastery of artificial intelligence, predictive analytics and big data can lead to significant profits for organizations that consistently outperform when these technologies become commonplace - but will these capabilities become ‘table stakes’? How will you compete in the digital age?

ETFs will benefit from active 2.0 as they are an efficient vehicle allowing widespread distribution. It is foolish to expect that strategies that can consistently demonstrate outperformance will be low fee products. They are differentiated and will be priced accordingly. ETFs are also the perfect building blocks allowing asset managers to build complex strategies using low cost, efficient and liquid products and can benefit from the rise of active 2.0.


Conclusion

ETF market participants must expect hyper competition driven by advances in digital technologies. The ETF market is a hard market to be in but a harder market to be out of, given the level of growth to date and continued growth this product is expected to see. Our view is that organizations in the asset management industry need an ETF strategy, and all organizations in the ETF industry need a digital technology strategy.


Further reading from PwC

“Redrawing the Lines: FinTech’s growing influence on Financial Services” https://www.pwc.com/gx/en/industries/financial-services/fintech-survey/report.html

“Sink or swim: why wealth management can’t afford to miss the digital wave” http://www.pwc.com/gx/en/industries/financial-services/wealth-management-2-0.html

“Financial Services Technology 2020 and Beyond: Embracing Disruption” https://www.pwc.com/gx/en/industries/financial-services/publications/financial-services-technology-2020-and-beyond-embracing-disruption.html

https://www.pwc.com/gx/en/industries/financial-services/fintech-survey/report.html




http://www.pwc.com/gx/en/industries/financial-services/wealth-management-2-0.html




https://www.pwc.com/gx/en/industries/financial-services/publications/financial-services-technology-2020-and-beyond-embracing-disruption.html







Contact

Olwyn Alexander Partner, Global Asset & Wealth Management Leader [email protected] +353 1 792 8719

Nigel Brashaw Partner, Global ETF Leader [email protected] +1 617 530 4487

Marie Coady Partner, EMEA ETF Leader [email protected] +353 1 792 6810

Bill Donahue Managing Director, ETF Practice Leader [email protected] +1 617 530 7037

Peter Finnerty Partner, US Mutual Funds Leader [email protected] +1 617 530 4566

Tom Holly Partner, US Asset & Wealth Management Leader [email protected] +1 410 215 0627

Elizabeth Savino Partner, US ETF Leader [email protected] +1 646 471 0098

Maria Tsui Partner, Asia ETF Leader [email protected] +852 2289 1205

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