What Does 2019 Hold for ETFs?

Exchange-traded funds had an interesting year in 2018. On one hand, ETFs tracking various sectors and stock indexes were subject to the bouts of volatility that plagued many names in the final weeks of the year. Across the market, many sector-specific ETFs ended the year with dismal performance records, while few managed to eke out gains to finish the year.

On the other hand, though, 2018 brought many exciting and promising signs for the ETF space. Investor interest in these funds seems to have kept up its frenetic pace established in previous years. Inflows for U.S. ETFs for 2018 totaled about $295 billion, bringing the entire ETF space to a net asset base of around $3.4 trillion, per a report by the Wall Street Journal. While ETFs still trail mutual funds by about $15.3 trillion in total assets under management, the growth of this space has been rapid and relentless. Last year also saw the debut of 269 new ETFs and related products, while 151 funds closed down, including 50 ETNs shuttered by Barclays in April.

As 2019 begins, ETF investors and the broader financial world are attempting to suss out how this closely watched space will change in the months to come. While only time will tell, here are some predictions for the ETF industry in the next year.

In recent years, many ETFs have been on a so-called "race to the bottom," in which funds competing in a crowded space have moved to lower their expense ratios in order to entice customers. This race is likely to continue in 2019, as the biggest ETF issuers capitalize on their ability to generate revenue via other means. At this point, nearly three quarters of all ETF assets are held by funds with expense ratios lower than 0.20%, per the report. This applies not only to U.S. equity funds but also to fixed-income ETFs, international funds, and even specialty ETFs focused on socially responsible investing, precious metals and other strategies.

Of course, there's only so far that this race can go. Some analysts have predicted that 2019 will see the first zero-fee ETF. If and when this point is reached, fund issuers will be forced to deal with the prospect of cutting fees to nothing in order to remain competitive.

The ETF space is enormous, with thousands of different funds. 2019 is likely to bring about hundreds of new options for investors. As this happens, expect many funds to suffer from relatively low investor interest, which may translate to low asset bases. Funds without sufficient assets may suffer from trading and liquidity issues and may even ultimately have to close. Small funds tend to attract institutional investors with sufficient capacity to trade in these tight conditions, while individual investors are frequently left unable to seek out optimal trading spreads in these products.

ETF investors have long waited for a major rules change from the U.S. Securities and Exchange Commission (SEC). In recent years, there have been numerous failed attempts to level the ETF playing field by adjusting the way that issuers can utilize custom baskets to impact an ETFs trading and efficiency. As the regulation currently stands, some ETF issuers enjoy greater flexibility than others when it comes to replicating an ETF's index with regard to holdings. While it's difficult to say whether change will come down in 2019, as well as what that change might mean, the possibility remains that the SEC could significantly alter the ETF game this year.

Smart-beta ETFs, index funds focused on particular stock attributes like dividends or price momentum, saw marked drawdowns late in 2018. This was one of the first times that this group of relatively new funds experienced such volatility. If this continues into 2019, expect that sector funds and other marginal products will be hit hardest as investor caution increases.

Although there are hundreds of ETF launches each year, the space is still dominated by a small group of massive issuers. As time goes on and these companies are able to utilize their size to offer lower fees and greater variety, smaller issuers are likely to continue to experience pressure. At the same time, the size of the space has prompted smaller issuers to take on more diverse and differentiated products. One innovative strategy is a self-indexing ETF, a product which allows an issuer to cut the cost associated with licensing an index from S&P Dow Jones Indices or other index makers. Instead, these funds can build their own customized indices for institutional and other investors.