The Evolution of ETFs
ETFs have been an exceptional growth story in the investment management industry over the last 20+ years. From the days of the very first ETF, the SPDR S&P 500, to the launch of what is now the world’s largest ETF issuer, iShares, ETFs have come to capture the hearts and minds of investors. This disruptive technology has been a game changer to how investors build, implement, and manage investment portfolios.
A growing segment of investors have further embraced ETFs as an exclusive technology to build and manage asset-allocated portfolios. ETF strategists, as many of these firms are known, design and manage a number of investment strategies to add value not by individual stock selection but by putting a number of broad and granular investment exposures together in a portfolio.
As usage of these strategies has increased, so has the level of scrutiny on these boutique investment managers. More recent blunders by firms using ETFs have called into question whether or not ETF strategists indicate a short-term trend or long-term evolution of the investment management industry.
We at CLS believe to truly understand the answer to that and many other questions, investors must have a clearer understanding of where the industry started with ETFs and where it is now. More importantly, investors have to understand why ETF strategists exist and what they believe in.
In the Beginning…
Before the introduction of ETFs, advisors and institutional investors alike defaulted to placing their investments in the hands of active managers via pooled accounts or mutual funds. In the 1980s, this was the only mechanism for investors to gain access to the markets, and they were left to hope their fund managers could, over time, consistently outperform the benchmark he or she was measured against.
As time progressed, more and more investors awoke to two unfortunate realities. First, the process of accurately selecting the right manager was a long and tedious one, and due to limited transparency it often yielded little chance of getting the complete story behind investments. Second, numerous fees charged by a mutual fund provider could leave clients worse off than where they started.
These two effects, as documented in numerous studies[1], meant a limited number of traditional active managers were successful in delivering on their most important promise: a positive experience for clients that brought them closer to their long-term financial goals.
ETFs – A Response to Mediocrity
Investors clearly were not getting what they were paying for, and more importantly they were not getting what they deserved: a better overall investing experience.
For many of the first ETF issuers, such as State Street, iShares, and PowerShares, ETFs were a response to that growing need for a better experience. These firms worked tirelessly to ensure ETFs could serve as a lighthouse – a beacon of hope for investors desperately looking for another way to meet their goals. The ETF industry boiled down to a simple philosophy: picking outperforming managers was yesterday; building consistent investment solutions is now.
Getting Smarter with Your Beta
Over the last few years, there has been increased focus on risk management in portfolios. What has become clear to investors is while diversification is key to proper risk management, there are other ways to achieve additional risk reduction in portfolios.
What has also become clear is a need to more efficiently disaggregate an investor’s rate of return into more identifiable and consistent sources. This, in theory, could provide better opportunities to manage risk within asset class segments and help reduce the overall costs to manufacture.
As ETF providers have looked to the latest academic research in this area, many have found methodologies that accomplish this goal in the packaging of non-traditional indexes. These products are known as “smart beta” because they combine the best elements of active management with the consistency of passive investing. Smart beta ETFs target exposures in the market that mimic well-known investment strategies offered in the active management community but remove human judgement (and in many cases, human error) from the investing equation.