Beyond Indexing: ‘Alpha’ ETFs Threaten Mutual Funds

June 28th at 4:00pm by Tom Lydon

Exchange traded funds are becoming a larger threat to the asset pool of traditional mutual funds because of their ability to do more than passively track an index. Many of the newer ETFs on the market are aiming at outperforming an index, or gaining alpha, according to a recent report.

“It ends up being a hybrid between active and passive,” Ryan Issakainen, ETF strategist at First Trust, told Bloomberg News. “The ETF itself is still a passive instrument insofar as it follows an index, but the index is much more active than a traditional market-cap-weighted set of companies.”

The inherent tax advantages, lower fees, and tradability of an ETF has attracted investors and assets that rival the mutual fund industry. Asset managers have also been keen on the security selection process of a mutual fund and seek to combine this with the qualities of an ETF, reports Christopher Condon for Bloomberg BusinessWeek. [Where in the World is ETF Risk Today?]

“Investors are looking for broader solutions; those with exposure to global markets, as well as continued demand for alternative products,” he said. “You have two types of ETF products right now; the traditional structured products that came on the exchange, and then you have more of the ETF “tools” that are being developed. The ETF tools will never be part of a core portfolio. As it is often said, ETFs began as structured products that came on the market and they remain structured products on the market, Scott Burns of Morningstar said in a recent interview on AdvisorOne.

Which leads to the actively managed ETF space, a sector that could segue into further erosion of the mutual fund industry. Actively managed ETFs are in demand, currently, as the PIMCO Total Return ETF (NYSEArca: BOND) has proven that ETFs can take the best attributes of active management. The overall concept has proven successful thus far. [ETF Growth Creates the Need for More Education]

Other areas that ETFs have trail blazed includes hybrid, or rules-based indices. There is an active management element built right in to the index, and cost is much lower than that of a mutual fund. [PIMCO Total Return: ETF or Mutual fund Wrapper?]

Other indexing measures that are taking the basic ETF above and beyond are fundamental indexing, which involves index creation based on other factors rather than market cap weighting. Cash flow, or equal representation factors are utilized. “Relative Strength” is another strategy that uses proprietary screening methods such as “observable price signals.”

“How good is rules-based investing at generating alpha, and do people really view it as active?” Luke Montgomery, an analyst at Sanford C. Bernstein & Co said. “And there is still the educational hurdle of convincing investors that active ETFs aren’t an oxymoron.”

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

Tickers