How ETFs and Indexing Took Over Active Management

Index ETFs and mutual funds continue to gain market share at the expense of actively managed funds. According to Morningstar, more than $660 billion was added to index funds (ETFs and mutual funds) during the one-year period ending April 30. Over the same time frame, actively managed funds saw more than $300 billion of outflows. Index funds have captured more than one-third of total long-term fund assets, with an even higher market share within equity investment categories.

The appeal of index funds is understandable, given the comparatively high fees and lagging performance of actively managed funds over the past 15 years. Index funds are typically inexpensive, with annual costs ranging from 0.03% to 0.40% of assets. In comparison, many actively managed funds have annual costs of 0.85% of assets or higher.

In the low-return world expected by most forecasters, these savings can add significantly to accumulated wealth over long time horizons. A recent report from Standard & Poor's shows that in most categories, actively managed funds have lagged their respective benchmarks over five-, 10- and 15-year periods.

ETFs Drive Innovation

Market cap-weighted index funds include the aggregate holdings in the market, investable with low turnover, high liquidity and capacity. These indexes have the longest history, and still hold the majority of index assets. However, the growth of ETFs and proliferation of smart beta investments has transformed the once-sleepy indexing industry into a major source of financial innovation.

Research is the driving force behind smart beta investments such as fundamentally weighted index and factor-based strategies. Fundamentally weighted indexes screen and weight portfolios based on company-level measures such as sales, cash flow or dividends. They provide broad-based market exposure, but differ from traditional indexes by determining portfolio weights in accordance with measures other than market capitalization.

Factor-based strategies provide a slightly different approach to smart beta investing, emphasizing factors identified in academic research that explain investment return and risk. Factor-based approaches are designed to enhance risk-adjusted returns relative to traditional indexes, most commonly using the following factors:

Value: "Inexpensive stocks outperform expensive stocks."
Size: "Small company stocks outperform large company stocks."
Low volatility: "Less volatile stocks outperform the most highly volatile stocks."
Quality: "Stocks with high earnings quality outperform stocks with low earnings quality."
Momentum: "Winning stocks keep winning; losing stocks keep losing."
High dividend: "Higher income stocks provide superior returns."

BlackRock, the world's largest asset manager and a leading provider of traditional and smart beta funds, projects that smart beta ETF assets will reach $1 trillion by 2020 and $2.4 trillion by 2025.

Smart Beta Vs. Active, Indexing

Smart beta strategies occupy a middle ground between traditional index and active investment approaches. Smart beta funds are similar to passive index funds in their use of a systematic, rules-based framework to create portfolios. Smart beta strategies deviate from traditional index funds by emphasizing screening factors or weighting methodologies that may enhance returns relative to cap-weighted indexes. With the goal of beating an index, smart beta strategies occupy common ground with traditional actively managed strategies.

The rules-based approach is a differentiating characteristic for smart beta strategies, which avoid the subjective overlay found in most traditional active management approaches. Most smart beta strategies are tightly risk controlled, accepting slightly more risk than the index in order to capture incremental factor-based returns. Most smart beta products offer a middle ground in fees as well, carrying slightly higher fees than traditional index funds but lower fees than most actively managed funds.

Smart beta strategies may be more volatile than traditional indexes. Although long-term returns from factor premiums have outpaced the market, annual factor returns have varied widely, and individual factors can be out of favor for extended periods of time. Notably, small company stocks lagged large company stocks for much of the 1990s, and value stocks performed poorly relative to growth stocks during the technology bubble in the late 1990s. Small company stocks and value stocks were stellar performers during other periods, rewarding patient investors who stayed the course.

Although research is far from conclusive, there are plausible explanations for the existence of factor premiums. Some researchers think that factor premiums represent compensation for systematic risk. For example, small companies may be less liquid or more volatile. Consequently, investors must be rewarded for taking the incremental risk of investing in small companies. Time horizon may also play a role in factor premiums, as investors may receive a premium for longer-term, less liquid investments.

Other researchers point to behavioral biases in explaining factor premiums. Loss aversion, preference for lottery-like opportunities and the tendency of investors to chase recent winners are among the most commonly cited behavioral theories. Factor premiums associated with systematic risk factors are considered to be more likely to persist, while behavioral biases may reverse if investors recognize and modify their behavior.

Indexing Concerns Growing

Some investors worry that market segments dominated by index investors will crowd out active managers who provide vital price-setting and liquidity functions. Without the price-setting involvement of active managers, it is conceivable that there would be pervasive and extreme deviations between market prices and the intrinsic value of securities. However, despite the inroads made by index funds, the volatility of security prices provides evidence that a price-setting mechanism still functions. Despite the growth of indexing, there continues to be an ample supply of active investors motivated to identify securities that are incorrectly priced by the market.

Some investors worry about the growth in assets devoted to smart beta strategies, as well as rising awareness about factor premiums. BCA Research recently reminded readers of an insightful quote from the late Barton Biggs: "There is no investment idea so good that it can't be destroyed by too much money."

In the near term, the interest in smart beta may contribute to performance, but there is a risk that a smart beta bubble could burst if factor-based strategies are saturated with investor cash. However, given the systematic and behavioral underpinnings behind factor premiums, the benefits of smart beta may decline but not disappear.

Investors in index funds should consider the following.

Index funds may not always be the best solution. Actively managed funds may be compelling in market segments where indexes are more fluid, and today's index may not fully represent tomorrow's opportunities. For example, most emerging markets indexes reflect the past, but some of the most promising opportunities may be in companies benefiting from the growth of the emerging markets consumer. Actively managed funds may also offer risk management benefits, as most fixed income indexes are concentrated in companies or countries that have issued the most debt, potentially creating unintended risks.

Index funds aren't always cheaper. Some of the largest and most successful active managers offer funds that are competitively priced relative to index funds, while some narrowly focused index products are more expensive than the typical index fund. Looking beyond the expense ratio is also important, as trading costs may add materially to the total cost of ownership.

Understand the composition of the index and differences between indexes in the same market segment.Some indexes are narrowly focused at the country, sector or stock level, and material differences may cause seemingly similar indexes to provide different performance patterns. For example, three countries represent nearly 50% of a leading frontier markets index, while more than 40% of the index comprise financial services stocks.

Be realistic about expectations for smart beta strategies. Past performance is no guarantee of future performance, particularly when prior results are from historical simulations. Given the increasing popularity of smart beta products, it's likely that future return premiums will be lower than historical return premiums.

Understand the portfolio turnover and tax implications. Traditional index strategies may offer a dramatically different tax experience than certain smart beta strategies, with momentum strategies meriting particular attention. Momentum strategies typically turn over at a rapid rate, potentially creating high tax bills if held in taxable accounts.

Index investments should have a role in investor portfolios, providing a simple, cost-effective and tax sensitive means for gaining exposure to broad segments of the global economy. A diversified portfolio of index funds, selectively supplemented by active funds, is an optimal portfolio approach.

— Read What Is a Renaissance Investment Management Firm? on ThinkAdvisor.