Inflows to continue, but closures also expected to rise

Exchange-traded funds vacuumed up cash in 2022 to post their second-best year ever for net inflows, and while analysts expect the hoovering to continue, this year could also see more ETF closures as managers pull plugs on funds struggling to attract assets.

The global ETF industry saw net inflows totaling $856.16 billion last year, its second-highest level of annual net inflows behind the record $1.29 trillion gathered in 2021, according to ETFGI LLP, a London-based research and consultancy firm.

ETFs racked up net inflows last year despite financial markets that Philadelphia-based Bloomberg Intelligence Senior ETF Analyst Eric Balchunas called "brutal." The S&P 500 index's price declined 19.4% in 2022 — its worst year since 2008 — while the Bloomberg U.S. Aggregate Bond index returned -13%.

While last year's markets were tough, ETF closures were relatively few, Mr. Balchunas said.

If, as he suspects, markets remain challenging this year, some of the more "niche" ETF products likely will struggle to get flows and will close as increasingly cautious investors lean into core strategies, he said.

Mr. Balchunas isn't alone in expecting an uptick in ETF closures this year.

"There have been a historic number of ETFs launched in the past three years, yet no increase in closures the past two years," said Chicago-based Bryan Armour, director of passive strategies research for North America at Morningstar Research Services LLC, a subsidiary of Morningstar Inc.

Given the recent poor market performance and the more than 1,200 U.S. ETFs with less than $50 million in assets under management, "our research suggests there could be an increase in ETF closures this year," Mr. Armour said.

Still, ETF inflows overall are likely to remain strong in 2023, analysts said. One big driver Mr. Balchunas cited is a "good chunk' of money currently sitting in mutual funds – much of it actively managed – will likely extend the pattern of mutual fund asset migration to the ETF world, he said.

"One of our big themes is that tomorrow's ETF stars are yesterday's active managers," said Mr. Balchunas, who clarified that by "stars," he was referring to ETF players with the ability to amass substantial assets.

ETFs launched last year by three companies – J.P. Morgan Asset Management, Capital Group and Dimensional Fund Advisors LP — accounted for 68% of all the cash that went into U.S. ETFs launched in 2022, Mr. Balchunas said, citing Bloomberg Intelligence data.

J.P. Morgan launched its first ETF in 2014 and its first active ETF in 2017, J.P. Morgan spokeswoman Kristen Chambers said. It's now managing the two largest U.S. active ETFs, the $24 billion JPMorgan Ultra-Short Income ETF and the nearly $18 billion JPMorgan Equity Premium Income ETF, she said.

As of Dec. 31, 2022, J.P. Morgan's U.S. ETF suite totaled 46 products totaling about $87.5 billion in assets under management, she said. Of that $87.5 billion, $57.5 billion — or 66% — was in actively managed ETFs.

On Dec. 15, 2022, J.P. Morgan announced plans to convert four mutual funds – which as of Nov. 30, 2022, had assets totaling about $2 billion – into actively managed transparent ETFs in 2023, pending board approval. Last year, J.P. Morgan successfully converted four mutual funds into ETFs, Ms. Chambers said.

Like others, J.P. Morgan was initially hesitant about offering actively managed transparent ETFs but opted to proceed "because there was significant investor demand and we have a preference for transparency," she said.

"As it turns out, it's not as simple to copy a strategy as one would think, since the information available is only backward-looking," she said.

Capital Group, home of the American Funds mutual fund family, launched its first six actively managed ETFs in late February 2022. It currently has nine actively managed ETFs — five equity funds and four fixed-income funds — whose assets as of Jan. 4 totaled slightly more than $6 billion, a Capital Group spokeswoman said.

"I think the takeaway here is that ETFs were really like a breeding ground for passive and indexing," Mr. Balchunas said, "but more and more they're really becoming used by the biggest active managers in the country."

He sees ETFs as "the structure of the 21st century," and said that even those "hoping it would go away" increasingly have been capitulating.

"Morgan Stanley has to be the best example of this because they bought Eaton Vance, which basically gave them Parametric — (a) big direct indexing platform," Mr. Balchunas said, adding that he suspected Morgan Stanley thought direct indexing might be a way to "leapfrog" ETFs.

"Direct indexing has underwhelmed by all metrics, and that's why Morgan Stanley planning ETFs I think is the ultimate capitulation," the analyst said.

In August 2022, months after an internal memo unveiled plans for Morgan Stanley Investment Management to launch an ETF platform, the money manager filed to offer four index ETFs and two actively managed ETFs, all to be offered under its Calvert brand.

In November 2022, Innovator Capital Management LLC announced the listing of an ETF sub-advised by Morgan Stanley's Parametric Portfolio Associates LLC.

A Morgan Stanley spokeswoman declined to comment.

However, a report by Boston-based Cerulli Associates that was sponsored by Parametric said direct indexing remains poised to grow at a faster rate than ETFs, mutual funds and separate accounts over the next five years, and will top $800 billion in assets by 2026, Cerulli said in a December news release.

"Show me the flows last year," Mr. Balchunas said. "The DI hype train started six, seven years ago … so to quote Jerry Maguire, 'Show me the money.'"

He said he has had difficulty obtaining flow information from direct indexing providers, "and my guess is because it's just not good."

Mr. Balchunas said he doesn't expect direct indexing to rival or disrupt ETFs.

"Also, I am of the belief that ETFs are early in their disruption phase," he said. "We just got to a place within a decade ago where you could get your whole portfolio for like 4 basis points – that is going to disrupt for a couple decades."

Like, Mr. Balchunas, Morningstar's Mr. Armour also cited the ongoing asset shift out of mutual funds and into ETFs.

"The story here is yes … mutual fund assets are going to ETFs and that's sort of been the trend for a long time, and we expect it to continue," Mr. Armour said, adding that U.S. actively managed ETFs attracted about $74 billion of net inflows last year through Nov. 30, while actively managed U.S. open-end mutual funds had outflows totaling nearly $900 billion.

Though they have been gaining traction, assets of U.S. actively managed ETFs totaled about $343 billion as of Dec. 31, 2022, representing just 5.3% of total U.S. ETF market assets, the Morningstar analyst said.

"A big reason we expect active to continue to grow is because it's still just 5% of the ETF market," Mr. Armour said.

He cited three paths active managers can choose when it comes to offering ETFs. They can convert existing mutual funds into ETFs; clone mutual funds strategies and offer them as ETFs; or they can offer new strategies, Mr. Armour said.

Active ETFs accounted for 255 – or 63% — of the 406 new U.S. ETFs launched last year through Dec. 31, he said.

While last year's new launches included more speculative strategies like single-stock ETFs, this year is likely to see a shift toward products "that people are comfortable with during a higher risk environment," Mr. Armour said. In such an environment, active ETFs based on long, successful track records are likely to "really come into play."

When it comes to ETFs, active managers appear to have gotten over the transparency "hurdle," the Morningstar analyst said.

"And that's what's really going to open the floodgates," Mr. Armour said, adding that while he doesn't know whether the amount of active ETF launches this year will top last year's level, he suspects "it will continue to be high."