Hyper-personalization is on its way to transforming the world of exchange-traded funds (ETFs) with the advent of Electronic Index Funds (EIFs). This seismic shift promises to change the way we invest, bringing unprecedented levels of customization and investor-centric approaches. Hyper-personalization is becoming ubiquitous in fields such as medicine and commerce, but its entrance into finance marks a new era. The pressing question is, why is this necessary? How will it function, and how will it reshape the landscape of investment management?
The Necessity of EIFs
Investors have diverse starting points, biases, and unique preferences that stem from their circumstances, investment history, and goals. As the investment world increasingly moves toward fractionalization, traditional ETFs and funds, built for a non-fractional world, struggle to address this diversity. Electronic Index Funds, however, can be custom-built to deliver specific investment solutions that meet individual requirements, fulfilling the gap left by traditional ETFs.
How EIFs Will Operate
EIFs will operate electronically, globally, and technologically using a plug-and-play and fully automated model. Harnessing deep tech and fintech innovations, they will be underpinned by artificial intelligence (AI) and machine learning, which will allow dynamic portfolio adjustments that ensure seamless investor-centric fund construction. This new generation of funds will use algorithms that analyze market movements and investor preferences, offering an unmatched level of hyper-personalization.
The Appeal of EIFs
These hyper-personalized funds are expected to be adopted widely because of their significant advantages in generating alpha, diversification, transparency, lower costs and impact. Their transparency will allow investors to pay only for the alpha they receive. As a result, each investor will receive a uniquely tailored investment solution with diversified benefits.
How EIFs Will Transform Investment Management
EIFs will fundamentally challenge the status quo of index funds and ETFs (which operate as indexed funds), redefining the concept of passive investing. They will create a new category that blends the benefits of both passive and active management. This hybrid approach will introduce new strategies and curated mandates that can operate seamlessly and adapt quickly to market changes. EIFs will allow the Active fund industry to multiply investment opportunities, transforming from thousands of funds to millions. This shift will also diminish the industry's current dependence on market-capitalization (MCAP) indexes, encouraging a focus on product innovation instead of marketing and sales.
The Market Impact of EIFs
The hyper-personalization that EIFs offer will have a transformative effect on systematic risk by promoting portfolio innovation at the micro level. These funds will act as dampers to market volatility by diffusing risk across a wide range of portfolios and strategies. For example, if the S&P 500 were rebuilt daily with varying weights for different components, it would offer a different unique individualized solution with varying weights of the same 500 components while still being benchmarked to the common reference S&P500.
ETF Industry Resistance
Like many innovations, financial products follow an "S curve" of early adoption, exponential growth, and stagnation. ETFs have grown exponentially for several decades, but they are now on the brink of hitting the growth plateau. This means the sector will eventually slow down, as innovations typically do, despite the tendency for a portion of assets to remain sticky. However, EIFs are poised to replace ETFs over the next 30 years, just as ETFs replaced mutual funds in many portfolios. Initially, the ETF industry will likely resist this transformation, but the shift toward EIFs will be inevitable.
Problems with ETFs Leading to EIF Growth
While ETFs offer many conveniences, their structural issues are accelerating the rise of EIFs. Investors pay management fees averaging 10 basis points (bps) on assets each year. When compounded annually against the 10% historical return of the SPY (Since inception in 1993), this translates to a 1.92% reduction. Even though ETFs aim to mirror their benchmark index, they often deliver a net annual loss due to small tracking errors and fees, leading to consistent underperformance over time. The "free lunch" perception of passive investing is a myth, as overlapping mandates and concentrated holdings lead to hidden risks and costs.
Additionally, ETF premiums, discounts, and liquidity challenges cause discrepancies between market prices and net asset values, contributing to mispricing. Most ETFs are based on concentrated indexes, leading to disproportionate exposure to a small group of dominant stocks. This lack of diversification amplifies systematic risks, which are further increased by the herding behavior of ETF investors. Intraday trading liquidity can also tempt investors to deviate from their long-term strategies, resulting in emotional decision-making.
ETFs that operate as an index fund have to do a lot more to encourage alpha generating innovation. If ETFs don’t push in the direction of product innovation and continue to offer suboptimal returns, eventually the investors community will look beyond the “free lunch” positioning and will be willing to experiment with active strategies that redesign passive and deliver outperformance against existing Index funds.
The onus is now on passive investing to do better than replication at low cost. The passive exuberance against active management is undermining market diversity. Markets need both Active and Passive investing. Active investing is crucial for maintaining the integrity of capital markets.
Features of EIFs
The features that distinguish EIFs from traditional ETFs are rooted in superior indexing methodologies, factor improvements, and the electronic delivery of hyper-personalized investment solutions. EIFs are transparent and built on an indexing method that reduces concentration risk while delivering superior outperformance against the relative benchmarks. By improving the statistical factors underpinning investment strategies, EIFs can outperform conventional indexes and benchmarks.
Their electronic, global infrastructure is at home in a fintech-driven world. EIFs will allow investors to access curated, personalized investment portfolios that outperform standard index funds. Hyper-personalization ensures that every investor receives a solution that aligns with their preferences, style, and goals. With less reliance on market makers, lesser mispricing, lower intermediation costs, and outperformance investors have a compelling reason to experiment with EIFs.
EIFs will be easy to transform into securities and fund structures, creating multitude of opportunities for fractional investors and introducing entirely new investment frameworks.
EIFs can reduce operational costs, overcome geographical biases, tackle compliance and regulatory challenges, and establish a new secondary market—all while delivering alpha, embodying Victor Hugo's truth: 'You cannot stop an idea whose time has come.’
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