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ETF Investors Actively Chose Active Management in April

ETFs

By Elisabeth Kashner, CFA  |  May 9, 2017

April ETF flows showed the same old, same old—but with a twist. Investors continue to favor cheap, simple, vanilla ETFs, just as in January, February, and March (and as in 2015 and 2016). Active funds gained market share too. Unlike before, the gains are coming not just in active-only segments, but also in areas of the ETF marketplace where investors have a real choice. At the margins, in small increments, equity ETF investors actively chose active management. That’s new.

In April 2017, $37.1 billion flowed into U.S.-domiciled ETFs, growing the industry by 1.3%, which corresponds to a 17% annualized rate. Strategy-wise, vanilla and active funds won the race, increasing their market share, while strategic (smart beta) and idiosyncratic funds lost overall. The size of the win depends on whether one looks at dollars or market share.

April’s biggest winners on a dollar basis were boring old vanilla funds. Once again, vanilla funds increased their market share, pulling in 8% more of the flows than expected, given their starting weight of 72.3% of ETF assets. That’s an extra $2.3 billion dollars of April flows, on top of the pro-rata $28 billion explained by vanilla’s market share. Investors continue to favor simple, cheap, broad-based, cap-weighted ETFs. That’s the $2.3 billion dollar headline.

But there’s a sub-plot here. While vanilla funds captured the lion’s share of the dollars, active funds grew fastest, bringing in 41% more than expected based on their starting weights. Unlike March, when active flows went largely to segments without passive ETF options, this time it’s the real deal—in equity. Actively managed equity funds attracted outsized flows, even in segments where investors had vanilla choices. Although active’s April victory is small in dollar terms, at just below $50 million in the competitive segments, it looms large given active management’s relatively small base in the ETF landscape.

Vanilla and active ETF strategies outpaced the complex rules-based funds. Strategic funds, which FactSet defines as ETFs tracking indexes that base security selection and/or weighting on academically researched principles of security analysis, and which often go by the moniker “smart beta,"  gained $5.7 billion of inflows in April. But, that was $1.15 billion short of the $6.85 billion that would be expected to accrue to strategic funds, based on their market share at the beginning of the month.

An even deeper shortfall hit the idiosyncratic funds, the ones that track indexes that select or weight securities using a method other than academic security analysis. All but two of these oddball strategies lost ground. The worst hits were taken by the price-weighted SPDR Dow Jones Industrial Average ETF Trust (DIA-US), which lost $124 million in April, despite inflows of $3.66 billion to U.S. large caps, equal-weighted funds like SPDR S&P Bank ETF (KBE-US), which lost $93 million while the U.S. Banks segment gained $98 million, and exchange-specific funds like IBB, which lost $319 million even though its six competitor funds took in a total of $50.6 million. As a group, the idiosyncratic funds missed their target by 94%. Oops.

Here’s how it looks for the four ETF strategy groups in April. 

Flows Gap ($ Millions)

 

Active

Vanilla

Idiosyncratic

Strategic

Expected Flows

708

28,007

1,545

6,851

Actual Flows

1,001

30,314

97

5,699

Difference ($)

293

2,307

-1,448

-1,151

Difference (%)

41%

8%

-94%

-17%

As always, there are some subtleties to be teased out. I’ll dive into active management and a handful of smart beta approaches. Then I’ll turn to the vanilla funds, looking specifically at segments where they compete with other strategies. Spoiler alert:  Vanilla delivered solid results in April, except in alternatives. Vanilla alternatives? We’ll get there.

A Bit of History

The first active funds launched in 2008. This batch included areas of the market that were hard to index, such as commercial paper, and also segments that don’t technically require an index, such as currency funds that track exchange rates like EUR/USD, along with ill-fated active equity suites from PowerShares and now-defunct Grail Advisors.

Active management’s big breakthrough in the ETF space came with the launch of PIMCO Total Return Active ETF (BOND-US), run at the time by Bill Gross, which gathered $1 billion in assets in less than three months. With a global, unconstrained mandate, BOND opened up the Fixed Income Global Broad Market segment. Many other active bond ETF launches followed, with no closures to date. Despite recent entries from two passively-managed funds, 99% of the assets in the global broad market fixed income space are in these actively-managed funds.

It’s been either feast or famine for actively managed ETFs, with hardly any competition between active and passive. Only 23 of the 42 pre-BOND actively-managed ETFs are still traded today; the rest have since closed. Equity has been particularly tough for active management; only 0.18% of the assets in equity ETFs are in actively managed funds. Fifty-six of the 1,392 equity ETFs are actively managed, but only six have managed to cross the $100 million mark.  Forty-one percent of all actively managed equity ETF assets are in a single fund: First Trust North American Energy Infrastructure Fund (EMLP-US).

Until this month, most actively managed funds in competitive segments failed to capture much investor interest. The flows to active kept pouring into the cash-equivalents and unconstrained global bond funds.

But this April was a little different. A dozen actively managed equity ETFs outpaced their passive completion. The leader, InfraCap MLP ETF (AMZA-US), attracted $54.6 million, or 23% of the net flows to U.S. MLP ETFs, despite holding only 1.6% of the MLP ETF assets at the beginning of the month. Actively managed equity ETFs brought in $126 million in April flows, almost three times the $44 million that their starting market share would predict, all else equal. Fixed income stayed true to its historical patterns: active’s overall market share increased in non-competitive segments, but decreased in segments where passives compete. Congratulations to active equity ETF sales teams at Virtus, First Trust, and Davis for April’s breakout.

Active equity’s success eluded the strategic funds, which missed the mark in April, though some strategies bucked the trend. Out of 20 smart beta strategies, only five saw actual outflows, but another seven fell behind the competition. The outsized flows to multi-factor and fundamental ETFs couldn’t make up the gap left by the meager haul for dividends and value ETFs.

The table below shows the strategic winners and losers for April 2017.

 

Strategy

Expected Flows

Actual Flows

Flows Gap

Market Share Capture

Multi-factor

784

1,088

304

1.4

Fundamental

732

945

213

1.3

Growth

1,808

1,939

131

1.1

Momentum

81

194

113

2.4

Buy-write

9

86

77

10.0

Low Volatility

462

532

70

1.2

Duration Hedged

8

33

26

4.4

Technical

10

31

20

3.0

Currency Hedged Low Volatility

1

0

-1

0.0

Target Tenor

1

0

-1

0.0

Bullet Maturity Fundamental

3

1

-2

0.4

Target Duration

37

35

-2

1.0

Currency Hedged Multi-Factor

8

3

-6

0.3

Currency Hedged Dividends

9

-3

-12

-0.3

High Beta

10

-22

-32

-2.2

Volatility Hedged

13

-114

-127

-8.8

Optimized commodity

68

-85

-153

-1.2

Currency Hedged Fundamental

237

-310

-547

-1.3

Dividends

1,736

636

-1,100

0.4

Value

2,021

709

-1,312

0.4


Strategic funds are available in all asset classes. In April, strategic ETFs lost market share in every asset class except for fixed income. The gap was most pronounced in equities, on a dollar basis, but percentage-wise, the pain was most keen in currencies and commodities.

 

Strategic Flows Gap

Asset Class

$(Millions)

%

Equity

-796.8

-12%

Commodities

-268.6

-486%

Fixed Income

33.1

20%

Alternatives

-49.4

-91%

Asset Allocation

-52.2

-74%

Currency

-17.4

623%

 
Broad commodity ETFs, funds that cover a wide range of commodity types, lost $193.1 million in April. The broad market commodity segment is dominated by PowerShares DB Commodity Index Tracking Fund (DBC-US), a tenor-optimized fund which housed 35% of the segment assets at the end of March. A production-weighted, front month fund, vanilla iShares S&P GSCI Commodity Indexed Trust (GSC-US) contains the next 16.6% of assets. DBC-US suffered 65.4% of the losses, while GSC-US lost 13.9%. The uneven losses wound up increasing GSC-US’s market share at DBC-US’s expense. That adds up to a nasty month for optimized commodity funds.

Equity was more of a mixed bag for strategic ETFs. Strong inflows to growth funds were insufficient to balance weak flows to value. Multi-factor funds such as Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC-US) and Principal U.S. Small Cap Index ETF (PSC-US) gained traction, with inflows of $267.5 million and $105.7 million, respectively. Dividend funds gathered less than half the expected inflows, in part because Vanguard Dividend Appreciation Index Fund (VIG-US) suffered $96.8 million of outflows while PowerShares High Yield Equity Dividend Achievers Portfolio (PEY-US) lost $109.7 million. Inflows to First Trust Value Line Dividend Index Fund (FVD-US) and Vanguard High Dividend Yield Index Fund (VYM-US), at $99.6 million and $94.3 million, were not enough to keep the strategy competitive.

Meanwhile April’s success for Schwab’s Fundamental suite—$572.6 million in the door—were dragged down by the continued bleeding in currency-hedged fundamental strategies. WisdomTree Japan Hedged Equity Fund (DXJ-US) saw $352.9 milion in outflows. Strategic ETFs as a whole have struggled so far in 2017, despite some victories here and there.

Vanilla Funds Dominate

With Active winning big in percentage terms but small in dollars, and with another humiliating month for smart beta and idiosyncratic funds, those looking for big winners will be drawn, once again, to the plain vanilla funds. Honing in on segments in which 1,172 vanilla funds compete against other strategies, it becomes possible to see the scale of vanilla’s dominance.

Segments involving value, growth, and high dividend yields cannot hold vanilla funds, as they are constructed to deviate from the overall market. Others, such as U.S. Biotech and global broad market bonds simply do not offer a vanilla option at the moment, though the opportunity exists. Stripping out these segments allows us to analyze vanilla fund flows in their proper context. That context is huge, involving 1,174 funds and $2.17 trillion, or 77% of the U.S. ETF landscape.

The table below shows flows above/below expectations for each asset class and strategy, for segments where vanilla funds compete with active, idiosyncratic, and strategics.

Vanilla funds outperformed expectations in every asset class except alternatives, where two tiny volatility funds—one active, one strategic—unexpectedly captured $5.1 million in April flows, causing a relative shortfall in the basic vanilla VIX-trackers.

On a percentage basis, Vanilla dominated most strongly in commodities. In the huge and competitive equity segments, vanilla’s dominance was clear, with 6% over its pro-rata flows.

The developed markets ex-U.S. segment provides a rich example. As a bonus, it also shows the shift in assets from iShares’ legacy funds to their cheaper, sometimes broader core funds. iShares’ core gain in IEFA-US, and Schwab’s clear win in SCHF contrasts sharply with low-volatility iShares edge EFAV-US’s weak intake.  The table below shows all developed ex-U.S. total market funds with April flows over $10 million.  

The big winners offered broad-based, cap-weighted, dirt simple portfolios for pennies. IEFA-US costs six basis points per year; SCHF-US costs six. In contrast, expensive vanilla EFA-US costs 33 basis points, while low-volatility EFAV-US costs 20. It’s hard to fault investors for favoring cheap, straightforward options.

April 2017 looked much like the first quarter, with vanilla funds capturing market share at the expense of strategics and idiosyncratics. Once again, active was strong, but mostly with flows to segments where passives do not compete. It’s too soon to know whether the lone difference—the measurable uptick in active equity market share—will persist. 

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