For ETFs, Fixed Income Matters More Than Smart Beta

December 21, 2016

Exchange-traded funds are transforming the asset management industry. Since the financial crisis, more than $1 trillion of net new money has flooded into ETFs, while essentially zero has trickled into mutual funds. Outside of the retirement space, the game is over; ETFs have won.

For much of the past two years, the biggest hype in the ETF space has surrounded “smart beta” and “factor” strategies. These are strategies that use academic research and quantitative analysis to tease out new approaches to the market, including many that (research shows) tend to beat the market over long periods of time.

Value funds are the oldest example, but new, hipper versions include low-volatility, high-quality and even multifactor approaches.

Where Smart Beta Goes From Here

We’ve been told that smart-beta assets will hit $2.4 trillion by 2025, and that they’re transforming investing as we know it. They are so hot right now that you’re starting to see articles about smart beta being “crowded,” with people talking about fading hot factors.

It’s all true. Smart beta is exposing a huge portion of the actively managed fund manager world as factor-chasing frauds, in much the way traditional indexing exposed so many active managers as overpriced benchmark huggers. But as critical as smart beta is to the future of ETFs, fixed income is even more important.

While ETFs offer an efficient vehicle for accessing smart-beta strategies, there is nothing about smart-beta strategies that says they can’t be made available in other formats (separately managed accounts, mutual funds, even active strategies).

With fixed income, however, ETFs are transformational. Particularly in today’s market, gaining fixed-income exposure through ETFs is an order-of-magnitude improvement over other avenues, and that advantage is only going to compound in the future.

As a result, and despite a potential bear market in returns, I think fixed-income ETFs will be the fastest-growing corner of the fixed-income market over the next three years. In fact, I think we’ll look back on 2017 as “the year of fixed-income ETFs.”


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