The Most Important ETF Of 2016

Through April 2016, 772 ETFs had attracted net inflows from investors this year. The factors driving those flows are interesting for all products, but one stands out to me as more telling than the rest: the iShares Edge MSCI Min Vol USA ETF (USMV | A-69).

USMV is part of the new breed of "smart beta" ETFs that aim to use quantitative strategies to deliver superior risk/return results to investors. As the name suggests, USMV offers a low-cost portfolio of U.S. stocks that aim to deliver similar upside performance to the broad-based U.S. equity market with lower volatility.

Through April 30, USMV had pulled in $4.7 billion in net new money, making it the second-most-popular ETF of 2016, trailing only the SPDR Gold Trust (GLD | A-100). Thanks in part to those inflows, USMV had $12.4 billion in assets at the end of April, making it also one of the 50 largest ETFs on the market.

3 Key Reasons Behind USMV's Success

The rise of USMV is impressive for three key reasons:

1. It proves smart beta can scale.

USMV is the largest true smart-beta ETF in the world. Some might argue that funds like the $29 billion iShares Russell 1000 Growth ETF (IWF | A-93) or the $21 billion Vanguard Dividend Appreciation ETF (VIG | A-77) count as "smart beta," and academically, I'd agree. But both of those products are linked to "old school factors"—style and dividends—that have been around for more than 50 years. USMV is the first of the new, modern, factor-focused ETFs to exceed $10 billion in AUM. Its success helps vault smart beta into the mainstream and will embolden other ETF issuers to invest heavily into promoting similar products.

2. It proves that second-to-market ETFs can win.

Another impressive (and for the industry, important) thing about USMV is that it was not the first, and for many years was not the largest, minimum-volatility ETF.

The minimum-volatility space was opened up by the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-70), which launched in May 2011 and quickly brought in billions in assets. USMV launched five months later, and for awhile, lagged SPLV by assets.

SPLV is still a large and very successful fund—it has $7.1 billion in assets—but USMV has been able to steal the leadership position by offering a different—and to some observers, better—portfolio.

Specifically, the chief criticism of SPLV has been that it tends to overweight certain sectors like utilities, because it has a super-simple methodology that simply chooses the 100 lowest-volatility stocks in the S&P 500.

The fund is currently 14.1% utilities, compared with the 3.5% weight of that sector in the S&P 500. USMV, by contrast, uses the counter-correlations between individual stocks to create a low-volatility portfolio, even while holding some higher-volatility stocks, and constrains its sector overweights so that (for instance) it is only 8.8% utilities right now.

Chart courtesy of StockCharts.com

iShares was able to use this difference to carve out space for USMV as a potential replacement for both traditional large-cap exposure and SPLV itself. Its sales effort was helped by the fact that USMV outperformed both since inception.

The ability for USMV to steal the leadership position in the low-volatility space is important for the future of the ETF industry because it says something important about how the smart-beta space will develop in the years to come. Historically, the first ETF to launch has won all the assets. It's no coincidence that the largest ETF in the world is also the first: the SPDR S&P 500 ETF Trust (SPY | A-97).

For market-cap-weighted ETFs, biggest is usually best. All else equal, the bigger the ETF, the tighter its spreads will be and the lower its expense ratio, which are the two things market-cap-weighted investors care about most.

But in categories like smart beta, ETFs aren't just competing with one another on expenses and spreads; they're competing with one another on a risk/return basis. This kind of leadership can change hands rapidly. As a result, you'd expect assets to be more mobile, chasing from one fund to another.

I'm often asked whether we'll see more and more smart-beta products launch, and my answer is always yes—because just like in the active fund space, issuers will always be searching for the new hot hand that they can market. USMV shows this works and will embolden more entrants to come to market.

3. It solves, I hope, the biggest issue in investing.

This third point flies somewhat in the face of point #2, but based on conversations I've had with advisors, it at least partially holds true.

One of the great appeals of USMV is that it solves one of the biggest issues left in investing: bad behavior.

Inside the ETF industry, we spend far too much time and effort arguing over minute differences in expense ratios. This made sense when the industry was competing heavily with active funds charging 1% or more.

Back then, expense ratio deductions could save investors billions of dollars. Today we've gotten so close to zero on plain-vanilla expense ratios that we get excited when one issuer undercuts another by 0.01% a year. Those kinds of expense-ratio cuts are more about marketing than about helping people out.

Today the biggest gap in performance comes not from the products offered by the industry but by the way people use them. No matter what study you look at—Dalbar, Morningstar, etc.—there is a massive gap between the return of funds and the return of the average dollar invested in those funds. People buy high and consistently sell low, costing them (on average, depending on which study you believe) 1-3% per year in performance.

The beauty of USMV is that, by lowering the overall volatility of the portfolio, it should help investors ride out short-term volatility and therefore hold their positions for the long haul. That's more of a hope than a data-driven fact at this point, but it's intuitively possible (and even likely).

Conclusion

Of course, there are lots of potential issues with USMV. People worry that, as the popularity of low-volatility strategies go up, those trades could get crowded; people worry that USMV's success is mostly about performance-chasing; people worry that investors don't understand what they're buying.

I worry about all that too. But as I look ahead at the next few years of the ETF industry, the success of USMV in raising assets tells me that smart beta is here to stay. And if the behavioral benefits of USMV bear out, I'd even be convinced that that was a good thing.

At the time of writing, the author owned none of the ETFs mentioned. Matt Hougan is the CEO of InsideETFs and can be reached at [email protected].