ETFs are eating mutual funds’ lunch. And their breakfasts and their dinners.
In 2015 alone, for example, ETFs had net inflows of $242B. Mutual funds had net outflows of $125B. Expect the bleeding to continue.
There are many reasons for this trend – and many that indicate it will continue in the years ahead. The biggest reason, of course, is the new technology of ETFs is superior to the structure of mutual funds. While I truly believe mutual funds are one of the most important financial innovations ever – they brought diversified portfolios to the masses – ETFs are simply the next generation of diversified portfolios, and their primary benefit is lower overall costs.
One area of growth that will continue to erode mutual fund market share is smart beta ETFs. Also known as strategic beta or alternative beta, smart beta ETFs are rules-based portfolios built around factors instead of traditional, capitalization-weighted methods that guide most market benchmarks. In other words, instead of building portfolios around the most popular stocks, smart beta ETFs are built around fundamental factors, such as revenues, earnings, or technical factors like momentum or volatility.
There are a few reasons this is attractive. First and foremost, investors can now build portfolios that capture the essence of active management at a fraction of a cost – and they don’t have to worry about their portfolio managers waking up on wrong side of the bed and not executing the strategy. The smart beta portfolio, since it is rules-based and transparent, is disciplined and consistent. It’s a dependable building block for portfolio construction. In turn, portfolios should be more stable in their behavior, which, combined with lower costs, should enhance investor experiences.
It’s also noteworthy that mutual fund companies recognize the obvious intuitive appeal of smart beta ETFs and the clear competitive threat. Nearly all of the largest investment firms are now entering the ETF game.
What Could Slow Growth?