Passive still reigns in ETFs

Tough for ETF issuers to compete in passives

Passive management still claims the lion’s share of new flows into ETFs, but it is increasingly a drying well for issuers when it comes to innovation. In plain vanilla exposures, the only place to compete today is price. That is a rapidly disappearing playground when the basis points are already in the single digits for most asset classes.

It is in smart beta and active management where we are seeing real competition unfold these days. And with the advent of the ‘ETF Rule’ in the US, which opened up custom baskets to all active management newcomers, the red carpet has been rolled out for small and new issuers to enter the space.

ETFs may have been originally designed for the passive investor and, as of today, that is where the bulk of the assets lay. But for any firm wanting to innovate and differentiate itself in the crowded ETF playing field, active management and smart beta are two areas that seem to offer opportunity.

Active wave

Active management has recently been where we are seeing the most newcomers and the most ETF launches. Long an overlooked segment of the predominantly passive ETF market, 80 new actively managed ETFs launched in the first half of this year alone, excluding the slew of defined outcome ETFs (which are technically actively managed) that debuted in that period. If you include all ETFs launched in the first half of 2021 – nearly 200 – almost half are actively managed.

That is not a surprise. Between the non-transparent phenomenon luring in larger mutual fund managers and the new rules around custom baskets, there are many reasons for issuers to be drawn to active ETF approaches.

Yet anyone involved in the financial industry has borne witness to the long and disappointing history of active management in the mutual fund space. Outperformance of passive strategies is rare, and when it happens, it is almost never sustained over the long term. ETFs have been pulling assets away from mutual funds for years because of this.

They do not seem to do a much better job than mutual funds at achieving alpha, but their associated costs are lower – and cost is a key factor undermining active performance.

Smart beta’s uncertain appeal

Smart beta often seems like a compromise between active and passive management, as it pushes beyond the simplicity of cap-weighted indices but shies away from active investment decisions, as it still relies on an index, albeit sometimes a complex one.

Yet smart beta seems to provide sporadic – rather than sustained – outperformance versus plain vanilla cap-weighted strategies. Asset flows into these products lagged significantly last year, suggesting investors are sceptical of paying extra basis points to track some enhanced index that is not guaranteed to outperform a simpler one.

While smart beta aims to provide a different path of returns, it is often associated with the pursuit of alpha – that extra juice you may find as you veer away from simply tracking the market. Paying more (most smart beta ETFs are more expensive than their plain vanilla counterparts) to take on extra risk without the guarantee of extra return is anathema to many investors.

Yet alongside active management, smart beta has been a historic hotbed of innovation, and many interesting strategies have come from this space. But the bar for success is very high. Plain vanilla ETFs have much to recommend them, and all indicators suggest they will not be overtaken by other strategies for some time – if ever.

Investors may love the thrill of a cool, innovative idea – and as industry watchers, we love them too – but they know that passive vanilla ETFs need not be boring. Many investors use them in their own active strategies because their beta is a known quantity, meaning they have a “plug and play” aspect that can appeal to tactical strategists.

This story was originally published on ETF.com

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