Browne, who is currently Global Co-Head of the ETF Group at Cantor Fitzgerald, has been at the forefront of the ETF world since 1996, when he was a member at the American Stock Exchange and part of a group of market participants that developed the secondary exchange liquidity for the SPDR S&P 500 ETF— the first U.S. ETF introduced by State Street in 1993.
He recently visited OppenheimerFunds for a discussion with Head of Beta Solutions Sharon French about key trends in the ETF space, the biggest risks to the marketplace, and challenges he sees on the horizon for the fast-growing asset class.
Here are some highlights from their conversation.
Sharon French: What are the biggest trends in the issuance of new ETFs?
Reggie Browne: The biggest trends are focused around how to best engage two sets of clients: financial advisors from the ETF product perspective, and then institutions who are adopting them. What we’re seeing is new institutional users are coming in and demanding a higher level of product. They’re looking for ways to increase their portfolio performance. The mechanism that the ETF community has adopted is smart beta, intelligent beta. I just call them factors.
With institutions adopting factors, you’re finding a lot of similar demands from the client channel. When the client dictates what they’re looking for, the ETF community generally responds by creating a new product. I can point to some pretty creative products in the marketplace that were brought to market by one particular client set. The key trends today are factor-based portfolios, multi-factors – or smart beta.
As for trends around fixed income, because of the way the market’s structured, there’s not a lot of transparency of an actionable price in individual corporate bonds. But ETFs offer that transparency because they’re governed by equity rules, and so fixed income ETFs are changing this marketplace further. You’re seeing this $8 trillion marketplace called corporate bond issuance being transferred to the ETF industry by indexing, and that’s the most exciting thing we’re seeing in the fixed income ETF space right now.
French: Do ETFs present a risk to the industry or the marketplace? How have you been working to educate regulators about risks to the system?
Browne: You’re referring to the Equity Market Structure Advisory Committee, which I was part of. It met for two and a half years and was formed by former SEC chair Mary Jo White. I was the ETF voice there. With ETFs being 30 percent, on an average day, of the equity volume on U.S. exchanges, it’s important for us to think about how ETF characteristics and behavior can impact the marketplace.
Three years ago we came to the realization that the risks are not necessarily the size of the marketplace, or whether or not the markets are built to handle any inherent risks. It really comes down to wonky things like how does the market operate, versus what’s needed to make sure these ETFs function in a stressed marketplace. Refinement of the rules governing how exchanges operate in the new ETF era is essential.
The key question essentially is – as the industry evolves and product innovation adds layers of complexity in ETF basket composition – is the industry advancing education and disclosures to capture investor attention? The largest risk in the ETF industry is suitability risk to the mom and pop retail investor. While financial advisors play a key role in the area of diligence for their clients, some ETF-like products are not designed for retail portfolios.
French: What are the disruptors or challenges that you see on the horizon for the ETF industry?
Browne: In the intermediate view it’s going to be rising rates. There’s a whole class of investors who are not used to normalized rates. As rates rise, it’ll make ETFs more expensive to trade compared to today’s prices, particularly in emerging, developed and U.S. marketplaces. So I think that’s a risk. Longer-term, ETFs are ripe for disruption by customized portfolios designed on some app or some sort of platform that may remove the expense ratio from the ETF function. Competition – I think we’re going to see the first zero expense ratio ETF at some point – which will bring additional pressure.
Competition inside the industry is going to influence some changes in product styles – and this is really around single-factor beta products. So think about the S&P 500. I think that will come down to a basis point, or zero. Investment managers like OppenheimerFunds who bring out unique products based on internal intellectual property that actually performs in all-weather markets will be able to charge appropriately for it and be competitive.
French: What are the biggest risks you’re seeing and hearing about in the market? What caused the February market correction?
Browne: Given the policies of the Trump administration and the Federal Reserve, the marketplace has become complacent in the view that the economy will grow significantly. You’re seeing that the marketplace has become calm – where there’s no risk to the marketplace regardless of what’s happening around the world.
I started my career trading options – index and equity options – and any good person who knows economics knows the world doesn’t always operate in a safe boat. During the February market correction, you had an occurrence where the marketplace became fundamentally concerned around the outcomes of this administration’s policies.
Interest rates became a focal point, and then the marketplace became psychologically unglued for a moment. Professional users of options, including insurance companies, were selling downside protection as rates started to creep up.
Suddenly we had a confluence of factors that caused the marketplace to momentarily focus on higher rates. As the markets came down, people shorted puts. This factor basically suggested that the marketplace was short downside protection and S&P 500 options – and that caused a reaction.