ETF fund flows do a great job of showing what investors are doing. But day-to-day, week-to-week, and even month-to-month flows snapshot can be noisy, as a single large inflow or outflow can dominate a segment or a strategy and can even seem to counter a long-term trend. With longer horizons, trend-spotting becomes easier, and less noisy, and a half a year is a decent time horizon for evaluating ETF trends.
The first half of 2017 has shown that the trend to cheap, simple, passive investing is accelerating. Here are some of the highlights:
ETFs are hotter than ever, with $250.2 billion in net inflows
Cost matters, and investors are flocking to funds with rock-bottom expense ratios
Plain vanilla is a huge investor favorite, with significant gains in market share
Complex passive strategies are losing market share, especially so-called smart beta funds
Active management is on the rise, except in its former stronghold of fixed income
Are ETFs a Threat, or an Opportunity?
From the point of view of a traditional active asset manager—either in mutual funds or hedge funds—the above trends present a threat, as investors continue to demonstrate that cheap passives are not just a viable alternative, but are increasingly the go-to investment vehicle. ETFs, like hedge funds, are still a fraction of the size of mutual funds, but, unlike hedge funds, ETFs are attracting an outsized share of new investment dollars.
According to the Investment Company Institute (ICI), mutual fund assets stood at $14.7 trillion as of May 31. The $14.7 trillion includes stock, bond, and balanced funds, but excludes money market funds. According to FactSet’s ETF data, U.S.-domiciled ETFs held $2.98 trillion as of June 30. That puts the ETF market at about a fifth the size of the mutual fund market.
Yet ETFs gained $250.2 billion in net new inflows in the first half of 2017 (according to FactSet’s ETF flows data) in comparison to $81.1 billion to mutual funds during the same time period, according to the ICI. ETFs took in three times the new investment level of mutual funds, despite being only a fifth their total size. This means that ETFs grew at 15 times the rate of mutual funds.
The Vanguard Juggernaut
It gets better for passives (or worse for actively managed mutual funds).
According to the ICI’s 2017 factbook, index mutual funds comprised 19.3% of all mutual fund assets. Although the ICI does not break down weekly or monthly mutual fund flows into index and active sub-groups, we can assume for starters that about 20% of the 2017 mutual fund inflows went to passive funds.
If trends from recent years hold, that assumption will prove too meek. The reason? Vanguard, with two-thirds of its assets in passives (mostly mutual funds), has been on a tear. According to New York Times reporter, Landon Thomas, Jr. in the last three calendar years, Vanguard “scooped up about 8.5 times as much money as all its competitors. It is entirely possible that the $81.1 billion in mutual fund inflows or more went to Vanguard’s index funds.
There’s another reason that the ICI data points to worse conditions for traditional asset managers. While net inflows to mutual funds were positive in the first half of 2017, after two years of net outflows, all of the asset growth was concentrated in fixed income mutual funds, which took in $135.8 billion. Equity and hybrid funds suffered outflows of $41.2 billion and $13.5 billion, respectively. And that’s including the probable net inflows at Vanguard.
Hedge Funds in the Black, but Overshadowed
Hedge funds fared no better compared to ETFs.
According to Evestment’s Q1 2017 Hedge Fund Industry Asset Flow Report, hedge funds held about $3.1 trillion in assets as of the end of 2016. Evestment reports first quarter inflows of $21.88 billion. Should the second quarter prove similar, hedge funds would be on track to gather $43.76 billion in the first half of the calendar year. As a reminder, ETFs took in $250.2 billion thus far in 2015 on a base of $2.55 trillion at the end of 2016. Do the math: ETF growth is running about seven times larger than hedge fund growth.
It’s easy to see why ETFs and index mutual funds are gaining market share: investors care about costs, and have been turning to low-cost funds aggressively. This is as true within the ETF marketplace as it is amongst ETFs, mutual funds, and hedge funds.
According to the ICI, the median expense ratio for actively managed equity mutual funds in 2016 was 1.21% per year. FactSet’s ETF data reveals the median expense ratio for equity ETFs was .48% as of December 30, 2016. On an asset-weighted basis, actively managed equity mutual funds charged .63%, compared to .21% for equity ETFs. Either way, ETFs are two to three times cheaper than actively managed mutual funds. It’s not hard to understand how cost savings are driving flows to ETFs.
What’s even more striking is the movement within the ETF landscape. Over the first half of 2017, cheaper ETFs gained market share, while more expensive ETFs lost it. On a weighted-average basis, in segments where ETF strategies compete, ETFs that gained market share cost just 0.19% per year, vs. .27% for those that lost market share. Yes, you read that correctly; in 2017, an expensive ETF is one that costs more than .20% per year.
Asset-Weighted ETF Cost by Asset Class and by Market Share Gainers and Losers
One way to contextualize the impact of cost on ETF choice is to look at the 20 funds that attracted the most assets over the first half of 2017. Although these funds represent less than 1% of the U.S. ETF landscape by count, they captured half the flows during this period (50.5%, actually). Here’s a quick profile:
Median Expense Ratio: .07%
Median AUM: $33.6 Billion
Most recent launch year: 2012
The starkest view into the ETF fee wars comes from comparing funds that compete jaw to jaw for investor dollars. There are a few indexes that are so popular that each of the major issues offers an ETF tracking them; the S&P 500 and Russell 1000 are prime examples. All the ETFs that track these indexes are on the cheap side, costing .15%/year or less. But .15% can seem overly expensive when you can get the exact same thing for .10%. And that’s precisely what happened to these direct competitors: the cheapest fund gained market share, while the pricier one lost. Here’s a table showing the results:
Expense Ratio 6-30 (in bps)
Market Share Gainer or Loser
Flows gap ($ Millions)
iShares Core S&P 500 ETF
Vanguard S&P 500 ETF
SPDR S&P 500 ETF Trust
SPDR Russell 1000
Vanguard Russell 1000 ETF
iShares Russell 1000 ETF
Schwab U.S. Large-Cap ETF
Vanguard Large-Cap ETF
The Flows gap column indicates the level of flows above or below what one might expect based on pro-rata market share from the beginning of the year.
BlackRock cut IVV’s fees to .04% in October 2016, to match VOO’s and look what happened. In the first six months of 2017, the S&P 500 gained 9.34% on a total return basis. Yet SPY lost assets, while its less-than-half-price competitors grew, at approximately the same rate.
AUM ($ Billions)
Cost matters, even among dirt-cheap ETFs tracking cap-weighted indexes. These days, every basis point counts, as investors keep pinching pennies.
The fee wars have been hard on traditional active managers and some have ventured into the ETF market. As late entrants, they have found the need to differentiate their offerings from the plain vanilla funds that dominate the asset charts. They have gravitated to two of the four ETF strategies to accomplish this: so-called “smart beta” and active management (avoiding vanilla and idiosyncratic approaches).
Only one of these bets seems to be paying off, and only at the margins. In market segments where strategies compete, smart beta, which we FactSetters call “strategic ETFs,” has been losing market share to plain vanilla. Active management has made small gains in the equity space, with a few well-seeded new launches.
FactSet assigns each ETF to a strategy and strategy group, which makes it easy to spot industry trends. For example, the largest strategic fund, iShares Russell 1000 Value ETF (IWD-US) is tagged with the strategy name “value.” Vanguard High Dividend Yield ETF (VYM-US) is tagged with the strategy “dividends.” Both are in the strategic group.
Strategic funds have had a hard first half of 2017, losing $6.0 billion of market share to vanilla funds, in segments where strategies compete. These complex strategies had inflows of $30.8 billion. Strategic funds in competitive segments captured $22.8 billion of that. However, that’s not keeping pace with the industry overall. Strategic beta funds are growing, just slowly compared to their vanilla brethren.
The slow growth adds up to a lag, or the “flows gap.” The flows gap compares a fund’s net inflows to its asset-weighted pro-rata share of segment flows, based on starting AUM. For the first half of 2017, strategic ETFs posted a deficit relative to this pro-rata expectation. While strategic ETFs outpaced all other strategy groups in fixed income, they fell behind more severely in equity and fixed income. The table below shows the first half 2017 flows gap by asset class and ETF strategy group, in segments where two or more strategy groups compete, in billions of dollars.
The Equity: U.S. Technology segment shows the trends quite well in the table below.Vanilla tech funds took in $1.6 billion, with market share gains going to the two cheapest funds at the expense of the four pricier choices. Strategic funds took in a mere $1 million jointly, with all funds losing market share, except for John Hancock Multifactor Technology ETF (JHMT-US). These funds started from a far smaller asset base, so the shortfall is less dramatic than it may seem. That being said, it’s hard to get excited about $1 million of net inflows to five strategic ETFs over half a year.
Expense Ratio 6-30
Market Share Gainer or Loser
Flows Jan-June 2017
AUM and flows are stated in millions of dollars.
Is Active the New Passive?
While complex strategic ETFs are losing their luster, some traditional asset managers have begun launching actively managed ETFs, often transferring management styles and teams from their mutual fund suites. It’s been working, at least somewhat. Overall, active management is gaining market share among U.S.-domiciled ETFs, especially in equities. The $1.2 billion of additional inflows (in comparison to active’s year-end 2016 market share) is pretty impressive for a strategy that had only $12.8 billion in net assets in competitive ETF segments.
Amongst equity funds in segments where ETF strategies compete, five actively managed funds brought in $50 million or more above their pro-rata expectations for their segment. Three of these were new launches, bringing significant seed capital.
Principal Active Global Dividend Income ETF
InfraCap MLP ETF
Cambria Core Equity ETF
First Trust RiverFront Dynamic Developed International
Davis Select Financial ETF
However, there are a few caveats to that.
Most active ETFs have small asset bases. As of June 30, 2017, the median AUM for actively managed ETFs was just $39.1 million.
Plenty of active ETFs lost market share in the first half of 2017. The most notable is PIMCO Active Bond ETF (BOND-US), which saw $204 million in outflows, despite $453 million in positive flows to the segment.
Most importantly, when an ETF launches with a large block of capital, there is a possibility of cannibalization. That is, asset managers transferring assets from one fund, perhaps an existing mutual fund, to a new one.
Still, actively managed ETFs have made a big splash in 2017, with 33 new launches. Critically, 31 of these launched into segments where active ETFs compete with vanilla, strategic, or idiosyncratic funds. Their seed capital and subsequent asset gathering sums to $1.2 billion; this represents the active flows gap.
As traditional asset managers continue to look for a point of entry to the ETF landscape, actively managed ETFs may be their best bet. In the context of rising interest in ETFs and dwindling interest in older product types, a brutal fee war, and a clear investor preference for broad-based, cap-weighted funds over complex strategic or idiosyncratic ones, there aren’t any other viable options.
In the end, the most important participant is the investor. So far, in 2017, ETF investors are getting a great deal for themselves: simple, transparent, broad-based, cap-weighted exposure, for just pennies per year. Mutual fund and hedge fund managers’ losses have become ETF investors’ gains.