ETF Exchange

Here are the hottest topics in ETFs for 2016

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The "Inside ETF" conference, the biggest exchange-traded fund conference in the world, kicks off Sunday night with north of 2,000 participants and four days of packed events.

Despite higher volatility and lower returns, 2015 was another record year for ETF flows, with roughly $242 billion in net inflows, an increase of about 10 percent. By comparison, mutual funds had $125 billion in outflows.

That's $2.1 trillion in assets under management, and while it is still small in comparison to the roughly $11 trillion in assets under management at mutual funds, the mutual funds have been steadily losing assets for years.

That was enough money to attract a lot of new providers. Jeff Gundlach of DoubleLine Capital. John Hancock. Goldman Sachs. Eaton Vance. Even Kevin O'Leary of "Shark Tank" got into the ETF act last year.

There are now north of 1,600 ETFs, and more than 70 ETF providers.

I'll be reporting Monday and Tuesday from the conference. Here's an early peak at the hot topics everyone is talking about.

ETFs are cheap, and getting cheaper

How much lower can ETF charges go, and who's going to throw in the towel?

It's a race to the bottom. iShares cut fees on its "Core" ETFs last year. The iShares Core S&P Total Stock Market ETF now has a 0.03 expense ratio (that's 30 cents for every $1,000 invested). Charles Schwab immediately followed suit.

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What's it all mean? There's a serious price war going on, and investors are the winners. It means lower revenue for ETF providers, but they are hoping to make it up with more volume. It's a risky strategy. When the price wars are over, who will still be standing?

And it's going to get even cheaper. John Hyland, who used to run the U.S. Oil Fund, has founded a new company, PointBreak ETFs, designed to introduce lower-cost ETFs in areas that are still relatively expensive, like country funds (India or China), commodity funds, and thematic ETFs like HACK (cybersecurity), which charges 75 basis points.

Smart beta funds keep growing

"Smart beta" is the hot buzzword right now. What's smart beta? It's weighting an ETF index to anything that is not market-cap weighted.

Jeff Gundlach made a splash last year when he entered the ETF business with a smart beta bond fund. The biggest hit last year was the WisdomTree Europe Hedged Equity, which combined currency hedging with a smart beta strategy, where the stock selection tracks a dividend weighted European index.

But is smart beta really better than plain old market-cap weighted indexes? I have my doubts. Most of these funds haven't been around long enough to make a judgment. Let's face it, smart beta is just a variation of active management, and we know what that's done.

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Regardless. We're going to see a lot of smart beta this year because it's a relatively new product, and providers can charge a little bit more for them.

Or they hope they can charge more. Goldman Sachs entered the ETF business last year with an interesting product, the ActiveBeta U.S. large Cap Equity ETF, which tracks an index that uses four "factors" (value, momentum, quality, and low volatility) and costs only 9 basis points, well below the cost of other so-called smart beta funds, which usually charge 50 basis points or more.

Active management is coming—for better or worse

While active management has long been a big part of the mutual fund business, it is still a tiny part of the ETF business. But that is changing.

Jeff Gundlach did well last year with his actively managed bond fund. AdvisorShares, which runs several active management strategies that mimic a slew of different strategies, has not fared so well.

But this year, more active management will be coming, and in a different format. Eaton Vance will be coming with a "nontransparent" active ETF, that is, the investors will not know what the fund is investing in until many months later.

Wasn't that an advantage of ETFs, that you always knew what the fund was holding? I think so, but apparently the industry — most of which come from the mutual fund business — believe there is a market for this.

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Personally, I think more active management is confusing for ETF investors, and for registered investment advisers who invest client money in ETFs.

Why does active management persist, despite the growing popularity of passive investments that track indices? Because: 1) there is a huge industry that insists they are smarter than the market; and 2) there's more money in it than passive management.

The only good news is that active management ETFs will drive down the cost of active management. Whether that justifies the mediocre returns that active management has posted is another question.

Regulation of ETFs: Will the SEC kill the party?

SEC's new ETF plan

The Securities and Exchange Commission (SEC) is poking its nose into the ETF business. It recently announced it would begin looking into ETF sales strategies and disclosures and the suitability for investors of complex ETFs like leveraged and inverse ETFs.

Regulators are, for example, considering limiting the amount of leverage that could be used in an ETF portfolio.

The SEC is also concerned about trading in products that have limited liquidity, like junk bonds and bank loans. It is considering proposals to limit the amount of illiquid asset an ETF or mutual fund could hold.

Here's an example: The SEC may require that a fund's portfolio consist of at least 15 percent liquid assets, or assets that could be sold immediately. The other 85 percent must be able to be sold within seven days without affecting the price.

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That may sound reasonable, but it would make it very difficult to run, for example, a high-yield fund or a fund with bank loans. It may even limit some corporate bonds.

I'm ambivalent about this. I have never been a big fan of leveraged and inverse ETFs and do not think they are suitable for most investors. That's one reason I do not talk about them.

But investors who want to play in areas of the market with limited liquidity — like bank loans — should expect volatility and should not whine when there are market meltups or meltdowns in their asset class. I'm with the SEC on the whole "suitability" issue.

On the other hand, I'm not sure about banning them outright. Leverated and inverse ETFs are a tiny fraction of the ETF business. I also do not see a lot of evidence that these type of ETFs are a "cause" of market volatility.

Market structure: What role do ETFs play in market volatility?

Speaking of the SEC and volatility, it recently released a large, highly technical report on the Aug. 24 market drop, when the Dow Industrials dropped more than 1,000 points in the first few minutes of trading, only to reverse within a few minutes.

The SEC assiduously avoided blaming anyone for the drop — the cause was the Chinese currency devaluation — but ETFs, which were a large part of the securities that experienced delayed openings and volatile trading halts, came out looking a bit more like a victim than a cause of the problem.

Still, ETFs will be a part of the SEC's look into market structure in 2016. Expect proposals to tweak "limit up/limit down" rules that apply to stocks as well as ETFs.

What the ETF industry does not want is to be "blamed" for market volatility, or some writer penning ill-informed articles (or going on TV) proclaiming that "ETFs are unsafe" because some tiny ETF in some obscure illiquid part of the market had problems.

ETFs have been fabulously successful, saving investors hundreds of millions of dollars by putting them in low-cost ETFs that track a well-known market index and at costs far lower than they were paying to the mutual fund industry.

Now, the question is how to hold on to those gains. That will be a big part of the conversation here in Hollywood, Florida.