ETFs Moving Beyond Passive Roots

This isn't about derailment, but an industry focus in flux.

[This article appears in the December 2020 issue of ETF Report.]

The U.S. ETF industry has come a long way from its roots of low-cost marketlike passive investing. That initial value proposition of the index-based ETF wrapper has matured, and is now trying to break new ground to grow.  

Is this a good evolution when it comes to investing, or should we be concerned?
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From the original SPDR S&P 500 ETF Trust (SPY) to the 2,300-plus U.S.-listed ETFs today, we’ve witnessed a lot of them—many of them full of bells and whistles—come and go over the years.

This year, the shockwaves of a global pandemic hitting markets fueled a lot of fanfare around things like thematic ETFs, actively managed funds and even the arrival of nontransparent strategies.

Perhaps lost in the wave of new and right-for-the-time ETF tools that have dominated our attention this year was the simple idea that broad-based passive index investing with a long time horizon is still a sound strategy for anyone looking to weather the ups and downs of markets.

It’s been easy to wonder in 2020 if the originally—and predominately—passive ETF market of yore is also the ETF market of the future.

In truth, it depends who you ask.

Losing Focus
Some long-timers say that the ETF industry may have lost its focus as it’s grown, and got caught in the hype and the thrill of “what’s new.” Is the effort by issuers to keep feeding the beast with new fare leading the industry astray, away from the core benefits of ETFs in the building of a low cost, well-diversified portfolio?

A recent marketing campaign from ARK Funds, the poster child for successful active management, is a good example of that concern. The campaign, which takes aim at broad-based passive investors, ties back to a report the company calls “The Bad Ideas Report.”  

The gist of the message is simple: owning the market through broad-based passive products simply wouldn’t do for anyone serious about investing for the future. That type of investing, the firm says, is best suited for investors “afraid” of innovative companies, looking for the “comfort” of what they know has worked in the past.

According to ARK founder Cathie Wood, the campaign was meant to be “provocative” in order to jolt investors into thinking differently about investing. Nothing more. And, in fairness, the move is hardly representative of the industry as a whole.

But while ARK is all-in on active investing, it’s obvious that suggesting broad-based passive investing is cowardly would rub some people the wrong way. 

“Everyone likes to chase performance. A lot of managers crash and burn when they do something like Ark did,” said Rick Ferri, a well-known advisor, and founder of Ferri Investment Solutions. “You have to stay humble. I’ve been around the business a long time, and when we see managers get this confident, maybe the cycle is about to come to an end.”

Actively Catching Up
The increase in new launches and asset flows in the active management ETF segment suggests this space is just now catching speed.

A look at the new 230-plus ETFs that have come to market this year shows that 53% of new ETF launches (through Oct. 31) were actively managed ETFs. That represents more than 120 new funds in total, some of them in semi- and nontransparent wrappers. (Remember that daily transparency of portfolio holdings has been one of the most beloved benefits of ETFs over mutual funds since the beginning. Lack of transparency is now the latest in ETF innovation.)

Only 12% of the launches—about 29 new ETFs—were categorized as vanilla, according to FactSet data. And vanilla here goes a long way from a broad-based market-cap-weighted portfolio to include even thematic ETFs.

That’s not surprising: With some 120 ETF issuers in the market and more coming in at rapid speed—thanks to the lower-bar-to-entry courtesy of the ETF Rule—product development and innovation will try to go where few have gone before. At times, it may go places that don’t really seem to benefit long-term investors very much.

But the low cost, broad-based beta world—the cap-weighted funds of the world—is pretty crowded already. Unless it’s to bring in something infinitely cheaper—which is hard to do in the era of Vanguard, and with 0.03% expense ratios common in this space—finding a new tune and reaching a new crowd will take some clever thinking.

Hype Vs. Implementation
This concern about a veering industry focus aimed at growing the size of the asset pie, if we can even say that, may be more about confusing noise for implementation.

“There’s no question that launches have been much more focused on shiny objects or innovation, because asset managers are working hard to find opportunity in a very saturated market,”  said FactSet Director of ETF Research Elisabeth Kashner. “That’s reflected in the count of launches and closures,”

“But that’s what asset managers are doing,” she added. “ETF investors don’t have to follow what asset managers are doing. What we see in investor behavior is entirely different, and reflected in asset flows.”

As of the end of October, the biggest ETF creations comprised cheap beta products like the Vanguard S&P 500 ETF (VOO), with $23 billion in net inflows; the Vanguard Total Stock Market ETF (VTI), with $22 billion in net inflows; the iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD); Invesco QQQ Trust (QQQ); the Vanguard Total Bond Market ETF (BND) and so on (Figure 1).

“How many shiny objects do you find in that list of flows?” Kashner said.

Top Gainers (Year-To-Date Through Oct. 31)  FIGURE 1

Source: FactSet; data as of 10/31/2020

‘95/5 Phenomenon’
Eric Balchunas, senior ETF analyst at Bloomberg Intelligence, has been tracking the ETF market with a fine-tooth comb on a daily basis for a long time, and he best illustrated the difference between what we, in this industry, pay attention to, and what ETF investors are actually doing.

What we find fascinating when it comes to storytelling may be very different from how we actually invest our money. He called it the 95/5 Phenomenon (Figure 2). 

FIGURE 2

Source: Bloomberg/Eric Balchunas

“It can feel as though some of the non-Bogle-like shiny objects and ideas that are outside of dirt cheap beta are taking over, but they get a lot more press because they’re more interesting to talk about,” Balchunas said. “But there’s plenty of money going into cheap beta.”

“Theme ETFs are having a good year because of COVID-related themes,” he explained. “It’s an unusual year,  where the door has been opened a little more than normal to shiny objects, but at least two-thirds of the money continues to go to Bogle-like products.”

More Money In More Hands
ETF issuers that are bringing to market some of these ETFs that fall into the “shiny object” category may be finding success because they appeal to a new group of investors. As Ferri put it, they’re chasing “thematic-type hot money,” or traditional active fund buyers that are now entering the ETF fold for the first time. Some of the newest ETF issuers are veterans of the mutual fund world looking to break into the ETF space because that’s where their clients want to go.

That’s not a loss for the ETF industry, or a surrender to the noisemakers. That’s a win for the ETF wrapper itself.

As a market, U.S.-listed ETFs had attracted more than $350 billion in 2020 as of the end of October, putting the overall market close to the $5 trillion-in-assets mark—the bulk of which remains allocated to broad-based plain vanilla funds.

“More money dollarwise will continue to go to BlackRock and Vanguard, but it’s going to continue to get more dispersed,” Ferri said. “That’s not a signal that people are doing more of this new ‘other stuff,’ but that they’re doing more of it in ETFs now rather than in mutual fund wrappers.”

The data suggests there’s a disconnect between ETF issuers and ETF investors when it comes to new product ideas and actual demand for implementation. New is attention-grabbing, but it’s not always right for everyone.

“Product development hasn’t lost its way, but messaging perhaps has,” Ferri noted. “Part of the problem is that ETF issuers don’t want to advertise direct to retail. They want to advertise to advisors. But individual buyers, as a market, are 50x the size of the advisor market.”

Ferri says that if you want to grow your ETF footprint today as a new entrant, coming up with a novel idea is less important than messaging what actually sells: tax efficiency.

“Ark is doing that well, spot on, even if their latest marketing campaign misses the most important message,” Ferri said. “The way to get the audience to listen is taxes. You don’t want taxes. And ETFs give you that: They are cheaper and you don’t have to pay taxes at the end of the year.”