This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by David Dziekanski, partner and portfolio manager of New York-based Toroso Investments.
Allocators and investors in the smart-beta ETFs are arguably acknowledging that active and rules-based strategies offer more dynamic solutions for the current global investment environment.
Flows in these vehicles have increased significantly this year. When choosing a smart-beta fund, many allocators have used similar evaluation approaches as they would in the actively managed mutual fund space. In this world, fees and performance are key. We believe there is a lot to be desired with this approach.
In the active investment world, allocators prefer a manager to have as long of a track record as possible. This is true even though their investment approach likely has changed, or has at least been tweaked, over time. Similar to their approach to selecting an active manager, investors’ capital has also focused on smart-beta products with significant assets under management. There is a lot of that makes sense with this.
Rethinking Smart-Beta Approach
With size comes scale—and typically, cost advantages in the form of cheap expense ratios and liquidity. Despite this, we believe investors need to rethink their approach to selecting smart-beta products, and recent flows have shown that the marketplace is beginning to agree.
Ignoring potential undisclosed frictional costs associated with some of the largest smart-beta ETFs can be costly. Unlike active managers, smart-beta ETFs do not consider overlapping portfolio positions and rebalancing activity in other products, and their investment process rarely develops over time.
Instead of tweaking (improving) an existing product with significant assets under management, ETF issuers more times than not will opt to launch an entirely new product with those tweaks. For these reasons, we believe investors need to rethink their approach to sticking by the old guard or run the risk of missing out on some of the most innovative and creative approaches available today.
There are approximately 850 smart-beta ETFs in the U.S., with just under $500 billion in AUM. To put that into perspective, there are more than 1,800 ETFs, coming in at over $2 trillion in AUM in aggregate. That makes smart-beta products almost 50% of the ETF offerings available to U.S. investors, representing about a quarter of the overall AUM.
U.S. dividend tilts have been the most successful form of smart-beta funds by assets, coming in at $80 billion in AUM. The four largest dividend ETFs all top $10 billion in assets, and measure in at $57 billion in aggregate, making up over 72% of the dividend ETF assets under management: