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Strategic beta ETFs combine the best aspects of active management and passive indexing to help investors achieve specific investment outcomes
<p>Strategic beta ETFs combine the best aspects of active management and passive indexing to help investors achieve specific investment outcomes.</p>

ETFs and Advisors in 2017

Matt Hougan and Dave Nadig on the biggest ETF trends in 2016, and why advisors need to start thinking like institutional investors for their clients.

Ten years ago, if you were building small, low-cost, well-diversified portfolios for your clients using exchange traded funds, you were ahead of almost every other advisor out there, said Matt Hougan, the CEO of the Inside ETFs conference.

But those days are gone. They are no longer a differentiator. ETFs are the most recommended product by financial advisors and will most likely overtake mutual funds in total assets in eight years. In fact, the kind of well-diversified, low-cost portfolio that advisors simply could not have built on their own ten years ago, investors can now buy in fifteen seconds with a few clicks on their phone.

The challenge for advisors then, is to move from that ubiquitous approach and start implementing strategies that are customized for their individual clients but with the sophistication of the largest institutions. With the evolution of ETFs, from broad index trackers to those that employ factor tilts, ESG mandates or targeted investment themes, it’s possible.

That was the backdrop message as Hougan and Dave Nadig, CEO of the Bats Global Markets-owned, gave their annual presentation on the state of the ETF industry to advisors at the Inside ETF conference in Florida on Monday.

“ETFs won 2016 in an enormous way,” said Hougan. Consider that $284 billion dollars flowed into ETFs in 2016, 20 percent more than last year - and that only tells half the story, as $186 million flowed out of mutual funds, making an almost half a trillion dollar swing from mutual funds to ETFs. “They just crushed it. That’s Micheal Phelps in a shark suit.”

More broadly, there has been an $844 trillion net change between active and passive funds over the past year.  “Just breathe that number in for a minute,” Hougan said. “That’s $1.5 million a minute, or $25,000 every second, of every day, nights and weekends included.”

And in share of market trading, ETFs are winning too, said Nadig. ETFs account for some 30 percent of all trading volume. But while there used to be a high correlation between volatility in the market, as measured by the VIX, and ETF trading (as ETFs are easier for short term traders to move in and out of volatility), that’s coming down. “It’s not just short-term opinions,” he said. “It’s long-term conviction.”

But with that has come a flood of new entrants to the market. Showing a slide from Credit Suisse analyst Victor Lin, over the past three years some 46 new issuers have come to the ETF market; three have closed, and 40 of them have less than $1 billion in AUM. “They struggle for scale, but they’re here, because the active management story hasn’t been working, and they recognize ETFs are their window into passive.”

The proliferation of ETFs, and the ability of indexers to finely slice up every corner of the tradable universe, means investors can fairly easily get exposure to every product in every asset category.

But the lesser-told story is that along with that increasing ubiquity comes the price collapse across the board. Consider that SPY, the SPDR S&P 500 fund, went from a fee of .16 percent AUM when it launched, to .09 percent today. It’s nearest competitor is priced at .03 percent, an 81 percent decline in costs. There are similar price drops across all asset classes.

The darker side of the proliferation of these funds, Hougan said, is that advisors can no longer use them as a differentiator. They are the top investment product recommended by advisors and are likely on track to top mutual funds in total assets by 2025 “if not sooner,” said Hougan.

That means advisors who use ETFs need to “start thinking about your clients as institutions,” and invest the way institutions do, with more sophisticated thinking about both the products and the investor’s needs.

One of the ways this is happening is with the rise of so-called “smart beta” ETFs. There is nothing new about “smart beta” investing – it usually refers to factor investing, or adjusting an index by certain factors like value, momentum or size. These are the same kinds of strategies that institutional investors have been using to their advantage for decades.

Asset managers see smart beta as a way to solve for “fee compression,” Nadig said, hence the proliferation of funds using the strategies over the past couple of years in retail funds. Net flows into smart beta ETFs topped out in 2015 at $67.6 billion, though fell to a net inflow of $39.6 billion last year.

Even then, most of the money went not into the more exotic funds being sold under the smart beta moniker, but offerings from larger fund families that kept to more traditional factor investing, like Vanguard’s Value Index Fund (VTV) or iShares Edge MSCI Minimum Volatility ETF (USMV), or even the iShares Russell 1000 Value ETF (IWD).

Prices are compressing here too, from an average of a little over 60 basis points in 2012 to something near 25 to 40 basis points today, Nadig said.

But, he added, it turns out, investors do at least as poorly in ETFs and they do in mutual funds, by buying high and selling low. According to Nadig, investors in SPY likely lose about 5 percent of the index performance because of jumping in and out of the fund. Investors in HDV, iShares Core High Dividend fund, have done considerably worse.

Factor strategies, after all, can provide a premium over the broader market, but investors need to stay engaged in the strategies over the course of the cycle for them to bear fruit, Hougan said.

“What does this mean for advisors? It means you are still really valuable. Your primary value add to many investors is that you keep them from making these dumb mistakes,” he said. “Your role as the institution in their investment process is to help them avoid these things. So by all means, learn about smart beta, seek the right products, scrutinize them. But more importantly, fulfill your role as being that institution for your clients,” he said.

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