ETF Trends
ETF Trends

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.

For Illustrative Purposes Only

Now, for the first time, investors do not have to simply accept being married to traditional active managers in order to succeed. They have tools, smart beta ETFs, to assemble portfolios that more appropriately fit their risk profiles. More importantly, investors can now augment their portfolios to meet their investing needs going forward. This method relies on going beyond asset-allocation decisions to be more targeted. This key feature is what has made a small group of investors relevant to the investing landscape today – ETF strategists.

 Active vs. Passive – A War of Words

The rise of ETF strategists has sparked numerous debates on which is better suited for investors, active or passive investing. These debates have focused on this logic: Investors who believe in the foundations of modern portfolio theory would seek to be compensated more for higher levels of risk and some of that return can be a function of skill through active management. For many investors, ETFs would not fit that bill as a tool for enhancing returns through active management.

ETF strategists challenge that thinking based on a common set of principles, which are borne from the beliefs that investing can veer from tradition and clients deserve a better experience. ETF strategists have effectively diverged from traditional thinking by applying active-management techniques across portfolios of passively managed ETFs.

First, ETF strategists believe ETFs are powerful tools for building and managing investment portfolios. ETFs deliver unique benefits, including better liquidity, greater transparency, lower costs, and greater precision in exposure than traditional, actively managed strategies. ETFs are a better and more cost-effective technology than mutual funds, and they allow investors to build highly customized portfolios that consistently meet client outcomes.

Second, ETF strategists are huge proponents of the ability to accurately separate alpha from beta in portfolios. Alpha-beta separation has been an evolving topic in the investment industry as indexing has helped investors identify ways to access investment strategies and segments of the market more cheaply than traditional active management. ETFs have accelerated this disruptive trend through the introduction of smart beta ETFs.

Third, ETF strategists strongly believe the lowest common denominator to every investment portfolio is risk – not just return. The events of 2008 and beyond have created a clearer awareness that a greater amount of value-add can be delivered through appropriate measurement and consistent management of risk. The latest innovation in the smart beta concept, factor-based ETFs, can help accomplish this goal and are designed to allow detailed precision in investment decisions. This in turn has allowed ETF strategists to build and manage portfolios with a more systematic framework that applies institutional-level risk-management techniques for the benefit of everyday investors.

 Bottom Line – ETF Strategists Are On the Side of Investors

So what makes an ETF strategist different from the rest of the pack? Being an ETF strategist means so much more than simply utilizing ETFs in a portfolio; it means being on the side of the investor even when under pressure from traditional active managers. ETFs have provided hope to investors, and ETF strategists are increasingly becoming the embodiment of that hope. The days of simply selecting traditional active managers likely to outperform are long over.

ETF strategists now look to provide investors a new path to reach financial success. This approach is based on a solid foundation where innovation, cost, accessibility, and risk management help to build portfolios engineered for long-term success.

Despite some recent stumbles, we believe the role of ETF strategists in investors’ portfolios is still in its infancy and will continue to evolve. Building ETF portfolios is not about searching for some mysterious return called alpha; it’s about adding consistent value through active management of beta. ETF strategists will continue to push the envelope on behalf of all investors for one simple reason – investors deserve a better experience, even if some are not willing to provide it.

 

Joe Smith is a Senior Market Strategist at CLS Investments, a participant in the ETF Strategist Channel.

 

Investing involves risk. This material does not constitute any representation as to the suitability of any security, financial product or instrument. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice.
[1] Benham, Frank and Walsh, Edmund, Active Manager Performance: Alpha and Persistence (January 28, 2014). Available at SSRN: http://ssrn.com/abstract=2411783 or http://dx.doi.org/10.2139/ssrn.2411783