ETF Investors Loved Vanilla Funds In 2014

Industry lore has it that strategic beta funds are slowly stealing market share from vanilla ETFs, but that's not what 2014 fund flows data shows.

Plain-vanilla funds are as dominant as ever, with healthy inflows in proportion to their market share. ETF investors continue to favor these funds' low-cost, straightforward access to global securities markets.

Strategic funds—so-called "smart beta"—are indeed gathering assets faster than the overall industry, and faster than vanilla funds.

Market share and fund flows must add up to 100 percent, so some funds must be losing the race for investor dollars.

2014's ETF losers were the idiosyncratic funds—ETFs with antiquated or nonsensical construction rules. Funds like the single-exchange PowerShares QQQ (QQQ | A-48) or the price-weighted SPDR Dow Jones Industrial Average Trust (DIA | A-74) were among the losers. Great news, as I argued in a recent blog about QQQ's outflows.

But the good news goes way beyond any single fund. In 2014, ETF investors made sensible choices across the board, sending cash to broad-based, cap-weighted funds and to funds with clear, economically grounded investment strategies—strategic funds.

Four Types Of Strategies

ETF.com's strategy designations help us see these trends, as they allow us to parse ETF flows.

In 2014, ETF.com introduced the strategy designation for more than 1,600 of all U.S.-listed ETFs. These portfolio construction descriptors come in four flavors: vanilla, active, idiosyncratic and strategic. I defined these when I introduced them last May, and again a few days ago. Here's a quick guide:

Vanilla funds are the simplest. They're broad-based, cap-weighted, index-tracking funds meant to capture an entire market.

Strategic funds select and/or weight securities based on financial concepts such as financial statement analysis, macroeconomic assessments or risk metrics.

Idiosyncratic funds, in contrast, choose and distribute securities following nonfinancial rule sets.

Active funds have humans managing their portfolios. They don't track indexes.

Investors Getting Better-Grounded

The table below shows 2014 flows for each of these strategy groups, compared with what one might have projected, based on these groups' beginning market share. The "2014 Excess Flows" column shows how much more (or less) capital flowed into a strategy group than would be expected based on market share. 

Strategic beta's nearly $14 billion of excess is more than offset by outflows of $15.7 billion from idiosyncratic funds. And as I mentioned, vanilla funds pretty much kept even with expectations, bringing in 99.7 percent of their proportional flows, based on starting assets.

Think of it this way: Every dollar of the $280 million that flowed into the strategic fund FlexShares Quality Dividend (QDF | B-75) avoided price-weighted DIA, which saw nearly the same amount in outflows. I'm not suggesting someone sold DIA to buy QDF, but the overall direction is clear. ETF investors are selling idiosyncratic funds and buying strategic ones.

Broad-Based Bleeding Hobbles Idiosyncratic Funds

In my blog about QQQ's asset losses, I argued that those redemptions were a sign investors are abandoning old-school, oddball indexes in favor of more cleanly constructed tools.

QQQ was only one of 42 idiosyncratic funds to shed capital in 2014.

QQQ isn't even the only exchange-specific fund on the loser list. In 2014, iShares actually closed two NYSE-specific funds, iShares' iShares NYSE 100 and iShares NYSE.

The most dramatic asset flight came from depositary receipt-based ETFs. The depositary-receipt category—funds built entirely of ADRs rather than local shares—lost more $100 million, or about 16 percent, of its assets in 2014. Four of the 10 ADR funds closed in 2014.

Back in 2002, BLDRS Emerging Markets 50 ADR (ADRE | B-48)  offered groundbreaking access to emerging market large-cap stocks, but it's been displaced by funds like the Schwab Fundamental Emerging Markets Large Company ETF (FNDE | C-64), which took in $52.5 million in 2014. ADRE lost more than $35 million to outflows this past year.

Bye-bye, silly funds. Strategic beta funds are eating your lunch.

Plain-Vanilla Funds—Steady Flows, Tetchy Markets

Some folks will claim that strategic beta funds are eating vanilla funds' lunch too. A simple statistic will back them up: Vanilla funds' overall market share dropped 0.8 percent in 2014. Yes, you heard me right. Despite proportional inflows, which indicate continued robust health, vanilla funds lost nearly 1 percent of their market share to strategic funds.

So why am I so sanguine about the place of vanilla funds in the ETF marketplace? Remember, changes in net assets come from flows as well as performance. Since we know flows were proportional, this market-share drop must be attributable to performance.

The performance differential between strategic funds and their vanilla counterpart isn't about alpha. It's about geography. Strategic funds are concentrated in the U.S. equity markets, which posted some of the strongest gains in 2014. Vanilla funds are more widespread.

Take a look at the 10 largest ETF segments by market cap, as of Dec. 31, 2014. You'll quickly see that the ones with the heaviest vanilla presence tracked falling international or global markets, while the ones with more strategy diversity tracked U.S. indexes.

Vanilla-heavy segments like gold and developed-markets ex-U.S. finished 2014 in the red, while more varied segments like U.S. large-cap returned double digits.

Strategic beta is more heavily U.S.-focused than vanilla funds, with 83 percent of all strategic ETFs assets in U.S.-only portfolios, compared with 70 percent of vanilla funds. In 2014, when the U.S. markets outperformed virtually all others, U.S. exposure paid off.

Smart Moves

The takeaway: Vanilla funds are doing fine, and so are U.S. ETF investors. By adding cash to well-thought-out strategies, and by abandoning dinosaurs like single-exchange and ADR-only indexes, U.S. ETF investors are making smarter bets than ever.

At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kasher at [email protected].