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?
Though ETF growth has been extraordinary in recent years, there are still impediments to more explosive growth, at least for now. Major issues include educational hurdles (“What are ETFs?” “How are they traded?”), the inability to use them in 401k/defined-contribution plans, and the inability of distributors to identify or compensate fund flows. Another significant reason is the reluctance of many gatekeepers of institutional portfolios (pensions, endowments, foundations, etc.) to use ETFs. This may be due to insufficient expertise or, more likely, the difficulty of showing a clear analytical value-add by drawing significant contrasts between competing ETF products. This is key. The ability to compare and contrast differences in actively managed mutual funds or separate accounts has been an important service of investment consultants. This, however, is another opportunity for smart beta ETFs – and ETF strategists – to lead the charge for continued, outsized ETF growth.
ETF strategists will be able to help investment consultants and gatekeepers understand and contrast different ETFs. It isn’t just about comparing costs. It’s about digging deeper into the underlying factor strategies and indices, understanding how different factors interact with each other, and understanding that factors, like all investment strategies, have a rhythm and cycle to their performance. Factors work over time, but not all the time. Understanding when and where factors perform is important to knowing how to use them.
Factor-based indices, even in the same category, can have significant differences in risk and return characteristics. There are a variety of possible reasons for this: investment universe, factor definition, weighting scheme, rebalancing frequency, underlying costs, and many more. Since performance differences can be significant, due diligence is critical.
Bottom line: factor-based analysis and smart beta investments will become increasingly important in the years ahead. Better understanding can produce better investment results. And better investment results will produce better asset growth. ETF strategists who can educate consultants on factor-based investing and provide analysis, recommendations, and portfolios based on factors will open new doors and opportunities to help more investors.
Rusty Vanneman is the Chief Investment Officer at CLS Investments, a participant in the ETF Strategist Channel.