2016 Was the Year of ETF Investors Acting Rationally

ETF investor behavior in 2016 made tons of sense. Cheap, simple Vanilla strategies, which emphasize mimicking the market rather than taking bets against it, gained steam. More complex strategies proved to be a harder sell, despite massive promotion of the space. Tactical strategies, such as currency hedging fell out of favor.

The most sensible move: the continued deterioration of irrationally constructed funds – those that focus on the listing exchange, the IPO date, or the security type.  And don’t forget the cost savings. The median expense ratio of the 90 funds that attracted $1 billion or more was a mere 0.15%, which is well below the asset-weighted industry average of 0.24%. Is it any surprise that $180 billion of 2016’s net $283 billion inflows went to Vanilla funds that cost 0.15% or less?

ETF Asset Growth in 2016:  Plain Vanilla Funds Punch Above their Weight, Strategic Beta Lags

2016 saw fierce competition in the ETF asset-gathering arena. Among US-domiciled ETFs, broad-based, cap-weighted ETFs beat out more complex strategies on all fronts. As a group, Vanilla funds drew in more assets – by dollars, by percent, and, critically, in proportion to their starting market share – than their complex competitors. S&P 500 tracking funds single-handedly captured 17.7% of 2016’s net US ETF inflows.

The losers: complex strategies such as WisdomTree Europe Hedged Equity Fund (HEDJ-US), which saw $7.8 billion of outflows, and exchange-restricted funds like PowerShares QQQ Trust (QQQ-US), which suffered $2.5 billion in redemptions.

Here’s the big picture for 2016 asset-gathering for US-domiciled ETFs, by strategy:

The ETF Landscape, by FactSet Strategy Groups

FactSet groups ETFs into one of four main strategy groups: Vanilla, Active, Strategic, and Idiosyncratic. Each group combines many types of specific strategies, such as fundamental, low-volatility, or value.

Vanilla funds aim to replicate an investment opportunity set by covering the full investment universe, be it narrow like KraneShares CSI China Internet (KWEB-US) or all-encompassing, like Vanguard Total World Stock Index Fund (VT-US). By definition, Vanilla funds do not take bets against the market; they are straightforward passive market replicators. Vanilla funds dominate the US ETF landscape, with 72% of the assets as of December 30, 2016. The Vanilla strategy group includes bullet maturity bond funds and simple indexes with a currency hedge.

Strategic funds, sometimes called “strategic beta” or “smart beta,” aim to outperform their markets by applying well-researched economic and financial principles to security selection and/or weighting. Strategic funds deliberately take bets against the market. These funds are rules-based, applying their strategy regardless of market conditions. While Strategic ETFs have garnered much media attention, they have captured only a fraction of the assets: 22% as of December 30, 2016. The most popular strategies in this group include growth, value, and dividends.

Idiosyncratic funds also take bets against the market, but with a different type of rule-set. Some restrict the investment universe to a single exchange or security type, such as depositary receipts. Others apply simple weighting rules: equal dollars, equal shares, or fixed allocations. A third type uses environmental, social, or governance criteria. These strategies have lost favor in recent years. They currently hold only 5% of the US ETF assets.

Actively managed funds, in contrast, rely on humans to select and weight their portfolio securities. Active ETFs combine old-school stock-or-bond-picking with the advantages of ETFs – low costs, tax efficiency, transparency, and intra-day trading. Active funds have been growing in popularity, but from a tiny base. On December 30, 2016 they made up only 1% of the US ETF landscape by assets.

2016 Kind to Vanilla and Actively Managed Funds

One way to look at the strategy horse race is to look at growth rates. By comparing the capture ratio of 2016 flows to each strategy’s starting asset level, we can see which strategies have increased their market share over the past year. Critically, this analysis strips out performance, and focuses strictly on asset gathering. The results are surprising, in that they show Strategic funds losing steam relative to Active and Vanilla, while Idiosyncratic funds lost out significantly.

The table below compares the flows capture to the December 31, 2015 asset base. A capture ratio greater than 1.00 indicates that the strategy attracted a disproportionately large percent of the overall investment flow relative to its initial asset level.

Simply put, anyone who expected 2016 flows to mimic asset levels from the end of 2015 would have been pleasantly surprised at 2016’s Vanilla funds growth and flabbergasted by Active’s acceleration. But those who bet on Strategic funds or the Idiosyncratic group would have left their money on the table. The shortfall was $9.2 billion for Strategic funds and $15.9 billion for the Idiosyncratic ones.

Vanilla’s dominance was overwhelming. If you rank funds by the dollar amount of inflows, you will find nothing but Vanilla in the top 10, with capture ratios uniformly greater than 1.00. The next 10 include only three Strategic funds: Vanguard Value Index Fund (VTV-US), iShares Edge MSCI Min Vol USA ETF (USMV-US), and Vanguard High Dividend Yield Index Fund (VYM-US).

The accelerated asset-gathering in Vanilla funds would have been even stronger but for a big trouble spot: $7 billion of outflows from currency-hedged ETFs. Currency hedged ETFs saw $20.6 billion in outflows during 2016. The simplest of these – funds that track a broad-based, cap-weighted index with a dollar-hedged overlay – lost only half as much as the more complex currency hedged products that combine a Strategic index construction process with a currency hedge.

Vanilla’s brightest spot was in bullet maturity bond funds, which gathered assets at twice the rate that their initial asset levels suggested they would. And that might be an understatement, as almost all 2016’s “outflows” for Vanilla bullet maturity bond funds come from these funds maturing, and returning capital to shareholders, rather than ETF redemptions. Excluding the maturing funds, only one bullet maturity Vanilla bond fund saw outflows in 2016.

Actively managed funds grew super-fast in 2016, with flows capture rates nearly double the initial asset levels.  But this top-level figure doesn’t tell the whole story.  Actively managed ETF growth was concentrated in fixed income and commodities, with a few funds dominating.  Meanwhile, Actively managed equity and currency ETFs saw net outflows.

2016 flows to Active ETFs were hardly uniform. On the contrary, 90% of the net flows to Actively managed fixed income went to only six funds, topped by PIMCO Enhanced Short Maturity Active ETF (MINT-US) and SPDR DoubleLine Total Return Tactical ETF (TOTL-US). Actively managed commodity ETF growth was even more lopsided, with 86% of it attributable to a single fund: PowerShares Optimum Yield Diversified Commodity Strategy No K-1 Portfolio (PDBC-US).

Strategic Funds Asset Growth Fell Short Overall

Of the 20 research-based investment strategies available in an ETF wrapper, four had a banner year. Well-established value and dividend strategies jointly pulled in $40 billion, with another $19 billion flowing to newer low volatility and fundamental approaches. These four strategies grew at an accelerated pace, with flows capture ratios up to 3.7. But currency-hedged fundamental funds bled assets, losing $13.6 billion in 2016. Currency-hedged low-volatility funds lost nearly all their assets, but started from a much smaller base.

Here is how it breaks down for all strategies with inflows or outflows of $1 billion or more:

The Biggest ETF Strategy Loser of 2016

Overall, 2016 was unkind to the Idiosyncratic funds, which saw net outflows, rather than inflows. Again, the losses were concentrated. The real losers here were the restricted universe funds: funds that track indexes that are defined by exchange membership, security type (depositary receipts), or IPO date. These distinctly non-academic selection funds saw $2.5 billion in redemptions in 2016, with single-exchange funds bearing the brunt.

Here are the significant (over $1 billion) flows for exchange-specific funds in 2016:

These losses overshadowed the successes of other Idiosyncratic strategies, especially ESG. Environmental, social, or governance-oriented strategies gathered significant assets in 2016, with net inflows to 17 of the 21 such funds. The leader, SPDR SSGA Gender Diversity Index ETF (SHE-US) gathered over $250 million in assets since its International Women’s Day launch in March 2016, making it the fourth-most-successful launch of the year. But SHE was hardly alone. Half of all ESG funds listed today launched in 2016.

What Will 2017 Bring?

If 2016 is any guide, 2017 will see more steely-eyed rationality from ETF investors.  In most asset classes, this means a relentless push for cheaper market access, and a show-me attitude towards complexity and tactical approaches.  In fixed income, active management may continue to accelerate.  Outside of fixed income, active could well face ongoing skepticism. And those Idiosyncratic restricted universe funds? The latest launches in that space came over eighteen months ago, in June 2015 – two geared biotech funds that happen to offer pretty vanilla-like exposure to the industry.  Outflows from the Idiosyncratic restricted universe fund and zero launches in 2016 says it all.