ETFs 2.0: New Funds, New Strategies in a Growing Market

Ben Johnson, Morningstar's director of global ETF research, set the stage for the ETFs 2.0 panel discussion at the 2015 Morningstar Investment Conference with an overview of the growth of the ETF market.

Since the first U.S. ETF was launched in 1993, assets invested in ETFs have grown at a rapid clip to more than $2 trillion today, driven by a secular shift to passive investment strategies. Most of this money is invested in traditional market-cap-weighted funds. Strategic beta funds, which blur the lines between active and passive investing, represent the bulk of the second generation of ETFs (ETFs 2.0).

Michael Arone, from State Street, argued that strategic beta (or "advanced beta," as State Street calls it) includes rules-based funds that weight their holdings using something other than market capitalization. Doug Yones from Vanguard agreed and argued that these funds may introduce unintended bets through sector tilts and that it may be possible to get comparable exposure through market-cap-weighted funds. Matthew Raynor of BlackRock/iShares explained that strategic beta funds aren't necessarily better than market-cap-weighted alternatives, but they can be useful because they allow investors to get exposure to risk factors they want.

Arone pointed out that market-cap-weighting has its own problems, including giving larger weightings to past outperformers, which may be expensive, and at times (such as during the late 1990s) it may result in large industry weightings, which can be risky. He argued that advanced beta funds may offer higher returns over the long term and may help investors better reach their goals. But with the proliferation of choices, good due diligence and financial advice is critical, Raynor pointed out.

Data mining is a risk with alternatively weighted funds. Vanguard published a study that found alternatively weighted indexes significantly outperformed during the back-tested period before they went live, but that outperformance vanished after they went live. This suggests there may be an element of data mining behind some of these new products. Arone explained that providers have an incentive to launch many products to attract assets, even if those strategies may not be successful over the long term. To guard against that bias, his firm (State Street) attempts to separate product development from research, and let the research drive product development. He suggests that there are only a handful of factors with compelling empirical evidence that they may outperform over the long run. Similarly, Raynor and his team listen to the research to identify strategies with lasting merit.

Investors are also increasingly using index products to make active bets. Raynor explained that investors are substituting ETFs for active funds. Low fees, coupled with active managers' disappointing collective performance record is creating a favorable environment for ETFs. Investors are also demanding more nuanced asset allocation.

Yones argued that ETFs become more attractive as it becomes more difficult for investors to find active managers who consistently outperform. ETFs give investors the freedom to express their macro views directly. Arone argued that investors are increasingly focusing on factor risk exposures and are using ETFs to actively manage this risk.

There are also a handful of actively managed ETFs, which have received a lot of attention in the press, but most have not attracted significant assets. Traditional active fund shops are interested in the ETF structure as a way to broaden their distribution channel, reduce cost, and improve tax efficiency. However, the requirement to offer daily transparency has prevented many from participating in the ETF market. ETFs may also be problematic because managers would no longer be able to close their funds if necessary. Yones explained that further refinements to the ETF structure are required in order for active managers to become more comfortable with it.

Asked for his predictions for ETFs 3.0, Yones hypothesized that there would be more fixed-income product innovation. Arone predicted that there will be consolidation within the industry, where smaller providers partner with larger firms. He also predicted that there will be more focus on the optimal way to combine factors. Raynor believes there will be more focus on developing sound core holdings, though he seconded Yones' prediction about fixed-income product innovation.