February ETF Flows Point to Opportunity

February 2017 was a great month for ETFs, with $46.7 billion of new net inflows. Continuing 2016 and January’s trend, ETF money flowed disproportionately into vanilla funds, increasing vanilla’s market share at the expense of the strategic group (the so-called “smart beta” funds) and idiosyncratic funds during February. 

FactSet classifies ETF strategies into four groups: vanilla, active, strategic, and idiosyncratic. Vanilla funds track broad-based, cap-weighted indexes. Active ETFs have humans at the helm. Strategic funds, often marketed as “smart beta,” apply well-researched investment and economic principles to security selection and weighting. Idiosyncratic funds take a non-standard approach, such as price-weighting, exchange-specific selection, or principles-based selection and weighting.

It’s not that all the strategics and idiosyncratics are losing assets, though iShares Edge MSCI Min Vol suite’s $639 million February outflows might make it seem that way. It’s more that strategic and idiosyncratic funds are losing market share by gaining assets at a lower rate than vanilla funds. They’re slow growing themselves to a decreasing footprint.

As you can see in the table above, vanilla ETFs took in over 77% of all ETF inflows in February; that’s more than its beginning market share of 72.1%. Vanilla’s ratio of net flows to starting market share was greater than one, which translates to an increase in market share.

Meanwhile, strategic approaches gathered only 18 % of net flows, despite a starting 21.9% market share. That’s like handing over one dollar out of every five to Mr. Vanilla. Idiosyncratic funds did even worse, capturing only half their expected flows.

The ETF industry is hungry for new opportunities. With strategics and idiosyncratics losing market share, asset managers are wondering how to best ride the ETF wave. 

Could plain old vanilla hold the key?

February ETF flows data suggest that it might not be that simple. It turns out that February’s other themes were “active on the rise (except maybe not),” “cost matters,” and “giants are attractive but vulnerable.”

Does Active’s Acceleration Spell Doom for Passive ETFs?

Active ETFs pulled in over two dollars for every one that they might have expected given the initial market share in February. February net flows were an impressive $46.7 billion. Expected active net flows, based on market share alone, should have been $544 million. Yet actual inflows were $1.12 billion. If things continue this way, Active ETFs will indeed soon conquer the world, kicking passives of all stripes to the curb.

Except that $875 million of the $1.125 billion went into segments where there are no index-tracking ETFs. Surprisingly, there are 28 segments without a single passive ETF option. ETF investors wanting to access, for example, global high yield bonds or U.S. investment grade short-term bonds have no choice but to go active.

This is how the ETF competitive landscape looks for the nine Active ETFs that attracted a minimum of $50 million in February. Hint: active has little competition here. 

True, there is one passively managed broad-based global bond ETF, SPDR Dorsey Wright Fixed Income Allocation ETF (DWFI-US). But DWFI is no core holding; it’s a momentum-based fund-of-funds that is limited to SPDR’s fixed income ETFs. As of March 2, 2017, DWFI held convertibles, junk bonds, preferreds, and some intermediate-term corporates, making it perhaps more like equities than a traditional bond fund. It’s easy to see why stability-seeking bond investors prefer active management when this is the only passive alternative.

The question remains: Why are there no passive options in these segments?

Sometimes passive simply won’t work. Some of these active funds, like top active inflows winner PIMCO Enhanced Short Maturity Active ETF (MINT-US), offer exposure to areas of the market that are difficult to index and virtually impossible to track, in MINT’s case, commercial paper. Passives aren’t going to make much headway in such a short-term, diffuse market. 

But that’s hardly the norm. In other segments, especially global bonds, both broad-based and corporate, and short-term, investment grade U.S. bonds, indexes are well established and eminently trackable.  There’s clearly room for passive management here.

When investors do have a choice, passive is winning. In February, among segments that have solid passive options, only 36 actively managed funds increased their market share, 51 had no flows, and another 22 had outflows. More strikingly, active management in equity ETFs took a $168 million dollar hit, as the AlphaArchitect suite shed its active status, switching to index-based exemptive relief. All told, active management in segments where investors can choose passive lost market share, pulling in only half the assets that their starting market share would imply. 

It seems logical that there’s opportunity for well-designed passives in the active-only segments. There’s investor interest in these segments, with nearly $22 billion in AUM and over $700 million of net inflows in February alone.

The ETF Market Chooses Vanilla

As we just saw, February’s ETF investors piled on passives over actives (given the choice), and into vanilla funds over strategic and idiosyncratic strategies. Digging deeper, we find that only rarely did investors deliberately choose a non-vanilla strategy. Parsing the ETF landscape into segments where passive vanilla exposure is a choice and those where no vanilla choice exists reveals that wherever a choice existed, ETF investors’ decisions went overwhelmingly to vanilla.

Notably, only one out of every nine investor dollars pouring into ETFs in February represented a deliberate decision against vanilla exposure. The 11% that chose some non-vanilla strategy in segments have both vanilla and alternatively constructed ETFs. In segments where vanilla funds compete with other strategies, vanilla outpaced the others almost 6:1, while redemptions ran a far more moderate 2:1. In total, in these mixed segments, vanilla dominated the other strategies by more than 5:1.

 Is it time to re-focus on plain vanilla?

The opportunities are easy to find. There are currently 10 ETF market segments that have over $1 billion in AUM but lack a single vanilla fund. Throughout the ETF landscape there are 113 segments holding $58.8 billion in assets with not one vanilla fund amongst them. Most of these segments have readily available broad-based, cap-weighted indexes that could easily serve as the basis for an ETF. 

Rejecting Expensive Vanilla

ETF investors have lately been seeking more than just vanilla. There’s a clear interest in large, established funds. There’s an even clearer distaste for expensive funds, as dollars keep flowing to dirt cheap ETFs.

The list of top segments tells us what exposures were popular among ETF investors in February. Ranks change month to month as market sentiment shifts. What’s interesting here from a longer-term perspective is not where but how investors deploy their cash. The “Winner ETFs” (top asset gatherers in each segment) have something in common: size. In six of the 10 top segments, the biggest flows went to the biggest funds. In three others, investors traded some size for cost savings. Only one—global gold miners—saw flows based on exposure.  

The biggest fund in the developed ex-U.S. total markets space, EFA, is pretty darned expensive at 33 basis points/year. Vanguard’s VEA, the second largest fund, costs only 9 basis points. Moreover, VEA offers exposure to both South Korea and Canada, while EFA offers neither. In VEA’s case, cost and exposure must have won out over size.

Something similar happened in the U.S. large cap value segment, where investors favored second-largest VTV (8 basis points) over costlier IWD (20 basis points). 

Emerging markets ETF investors flocked to the third largest fund in the segment, IEMG. For most of February, IEMG was the second cheapest in the segment, until February 24, when Vanguard dropped VWO’s fees to match IEMG’s. Even so, the difference was tiny; only one basis point separated IEMG from cost leader SCHE. So why the third biggest fund? IEMG is FactSet’s Emerging Markets Total Market Analyst Pick for a reason. To quote from FactSet’s fund profile, “IEMG offers outstanding coverage of emerging markets in a low-priced and liquid package.” It’s probably fair to say that February’s investors decided that IEMG offered the best balance of size, cost, and exposure in the emerging markets space.

Global gold miners are a more interesting case. GDXJ, the segment’s top asset gainer, is only half the size of the largest, most liquid gold miner ETF GDX. GDXJ is a touch more expensive, too, by 4 basis points. But that’s not really the point. GDXJ offers exposure that is totally different from GDX’s. That’s how VanEck manages to operate two funds in this seven-fund segment. GDXJ specifically focuses on small-cap gold mining stocks, while big brother GDX offers broad coverage of all market cap buckets. If FactSet’s ETF classification system parsed sector funds by market cap as well as by industry, GDXJ would be in a separate segment from GDX. And yes, GDXJ has the largest asset base of the small-cap gold mining ETFs.

To sum up February’s preferences, bigger was better in the ETF space, though investors were willing to go to the second or third largest fund in pursuit of cost savings. In the top 10 segments, flows-wise, these giants gained market share over their smaller, often costlier peers.

Would the Dollars Come to Cheap Vanilla?

Is there opportunity in today’s vanilla-free segments like U.S. Biotech, which continues to be dominated by iShares NASDAQ Biotechnology ETF (IBB-US)? (IBB selects only NASDAQ-listed stocks). The story of VEA, VTV, and IEMG just might point the way. In fact, during February, smaller funds managed to gain market share within their segments. So did cheaper funds.

The table below shows market share movement at the segment level, comparing the percent of segment fund flows against starting segment market share. Market share is a zero sum game; for every fund that gains, another loses, no matter whether the segment received inflows or outflows.

Total starting assets were higher for funds that lost market share within their segments compared to those that gained. This means that, on the whole, smaller funds gained market share over the larger ones. 

Costs were lower for funds gaining market share within their segments, averaging only .20% vs .27% for funds that lost market share. But that’s not all. Some segments saw no flows whatsoever in February. It turns out that funds here were nearly three times as expensive as those that gained assets. Costs mattered quite a bit in February.

Can Giants Be Displaced?

Some goliath funds seemed quite vulnerable in February. Tiny funds might still be tiny, but some of them are growing fast. Slice the ETF universe by assets under management reveals that market share increased fastest for the smallest funds, but actually fell for those with more than $10 billion in assets. The giant funds are growing, yes, but not as quickly as the ETF industry overall. 

Given the trends we’ve seen, with assets going to plain vanilla, low-cost funds, and not always to the largest fund in the segment, there are plenty of reasons to suspect that investors would welcome cheap vanilla options in every area of the ETF marketplace. There are 113 segments that have no vanilla funds. That’s $67.7 billion of opportunity.