'Absolute tsunami' of ETFs to hit market, and investors need to prepare now, says fund expert

The ETF market is poised for significant expansion as the SEC allows mutual funds to offer ETF share classes, potentially adding over 3,000 new ETFs to the existing 4,000. While this offers investors access to established strategies at lower institutional fees, experts caution about the historical underperformance of active managers and the potential mismatch of illiquid assets within the highly liquid ETF structure, particularly in niche markets like private credit, where demand has been limited despite new product launches.

Analysis

The exchange-traded fund (ETF) market is on the cusp of an unprecedented expansion, driven by an anticipated Securities and Exchange Commission (SEC) rule change permitting traditional mutual fund managers to offer ETF share classes of their existing funds. This development, termed a "game changer," could see the current count of approximately 4,000 ETFs nearly double, with financial futurist Dave Nadig forecasting as many as 3,000 new launches within a month, potentially bringing the total to over 7,000. Even prior to this rule change, 400 new ETFs have launched this year, indicating robust product development. While many new offerings will be relatively conventional, such as large-cap growth and core equity income strategies from established mutual fund firms, potentially offered at lower institutional fee levels, this proliferation presents a significant due diligence burden for investors and advisors. Nadig highlights that while over $400 billion has flowed into ETFs this year, with core products like Vanguard's S&P 500 ETF (VOO) on pace for record annual inflows (VOO sentiment: 0.8), significant caution is warranted. The historical underperformance of active managers relative to benchmarks remains a key consideration, though accessing these strategies via an ETF share class might be the most cost-effective method. More pointedly, concerns arise around newer, more esoteric ETFs, particularly those venturing into illiquid asset classes. For instance, the first private credit ETF, PRIV (sentiment: -0.8), launched by State Street (STT sentiment: 0.1) and Apollo Global Management (APO sentiment: 0.1), has seen very limited demand, raising only about $54 million and experiencing minimal daily trading volume, despite significant market attention. This contrasts with ETFs offering exposure to privately held companies, like the ERShares Private-Public Crossover ETF (XOVR, sentiment: 0.7), which holds positions in companies like SpaceX and Klarna (within a 15% cap on illiquid securities) and has attracted roughly $300 million, suggesting stronger retail interest in private equity. Nadig underscores a fundamental "mismatch problem" in packaging illiquid assets within highly liquid ETF structures, which can lead to capacity constraints and trading stress during market volatility. He suggests that alternative structures, such as interval funds or closed-end funds, may be more appropriate for less liquid investments, noting the SEC's apparent interest in increasing retail access to these vehicles. The overall market sentiment is neutral (0.05) but carries a cautious tone, reflecting these complexities and potential pitfalls despite the growth.

Key Decisions for Investors

• Investors should prepare for a significant increase in ETF offerings, necessitating thorough due diligence on new products, especially actively managed strategies and those investing in niche or illiquid asset classes.
• Consider new ETF share classes of established mutual fund strategies for potential fee advantages, but critically evaluate the historical performance of active management against passive alternatives.
• Exercise heightened caution with ETFs focused on illiquid assets such as private credit or private equity; assess the suitability of the ETF structure, underlying liquidity risks, and demonstrated investor demand, noting the divergent receptions of products like PRIV and XOVR.
• While core ETFs like VOO continue to attract substantial assets, investors should meticulously evaluate if specialized or leveraged ETFs align with their risk tolerance and if the ETF wrapper is appropriate for the underlying strategy, especially given potential liquidity mismatches.
• Monitor regulatory developments regarding fund structures for illiquid investments, as vehicles like closed-end funds or interval funds may offer more suitable access to private markets and could become more readily available.