Finally, Smart Beta ETFs Gain Market Share

After months of losing ground in the battle for ETF market share, smart beta ETFs picked up steam in September, especially in comparison to plain vanilla equity ETFs. Overall, these strategically-constructed funds gained $1.3 billion of market share in September. In segments where these funds compete with other fund construction types, smart beta funds picked up $1.2 billion of market share, while vanilla funds lost $2.4 billion. Other winners included idiosyncratically-built funds like SPDR Dow Jones Industrial Average ETF Trust (DIA-US) and active management.

The reverse was true in fixed income, where vanilla funds took market share from all other types—but to a far lesser extent. Fixed income ETFs had a great month overall, taking in $11.9 billion of new inflows. That’s not too far off equity’s September flows total of $14.6 billion. But market share in fixed income stayed pretty stable, with a swing of only $90 million.

FactSet classifies ETFs along several dimensions, including asset class, economic exposure, and geography. On top of that, we also tag each fund with a strategy, to explain how the fund’s index selects and weights its constituents. Some strategies are simple to understand, others take a bit of work. Vanilla funds reflect the overall opportunity set, including every investible security at its market cap weight. Strategic funds use research-based techniques for security analysis to build a portfolio. We also track idiosyncratic funds—ETFs that track indexes using antiquated weighting methods, or ones that serve some other purpose, such as ESG investing. Finally, we include actively managed ETFs, funds where a portfolio manager calls the shots.

Competing for Investor Dollars

ETF flows can tell us a story on any of these dimensions. For example, September’s money flowed to fixed income and commodity funds at a faster rate than their previous market share would have suggested, while alternatives and currency ETFs actually experienced outflows. Geographically, U.S.-focused ETFs brought in $15.8 billion, or 55.9% of all September new investment dollars, while Japan, Germany, and the U.S. lost $1.5 billion, jointly. On a percentage basis, tiny Global X Pakistan ETF (PAK-US) increased Pakistan’s ETF asset base by 35.7%, while eurozone-focused U.S.-domiciled ETFs lost 10.7% of their starting assets. 

However, there’s not much opportunity left to launch funds covering obscure markets, as the ETF landscape has become saturated. Over the 12 months through September 30, 2017, only 11 new segments launched in the U.S. ETF marketplace—and only half of these have assets above $10 million. There’s just not that much new ground to cover in terms of economic exposure, so issuers looking for new investors have to find some other way to compete. 

This month, three tricks worked: compete on price, offer complex strategies, or bring-your-own assets.  Let me explain.

The Price War Continues

Price competition has intensified in the ETF business, especially among broad-based vanilla funds. These days, the cost line in the sand is around 0.20% per year, with the biggest gains going to funds that cost 0.05% per year or less.

Here’s how it played out in September: 

 *Excluding SPY. Spy gets its own line in the table because its flows are super volatile, with $1 billion or more flowing in or out daily.  SPY’s flows are so large that they swamp other outcomes.

The picture is clear: investors are dropping funds that cost over 0.20% per year.

In September, vanilla ETFs offering exposure to developed markets outside the U.S. iShares’ MSCI EAFE ETF (EFA-US) had no inflows at all, while its in-house competitor iShares Core MSCI EAFE ETF swept in $2 billion. Same issuer, similar underlying index, but at a fraction of the cost. Why pay 0.33% when you can get the same portfolio, with additional small cap exposure, for 0.08%?  

Issuers understand where this trend is going. In September, Invesco PowerShares broke with its own tradition of launching ETFs with complex strategies, introducing a line of simple, broad-based, vanilla equity and bond funds. None of these costs more than 0.14% per year and each is priced within 0.01% of its cheapest competitor. Game on!

Complex Strategies Suddenly Attractive

Ironically, PowerShares’ primary strategy—sponsoring complex ETFs that take risks away from the broad market—got a shot in the arm in September. The gains in market share were real, and broke trend from most of 2017. Strategic funds—those that select or weight portfolio constituents based on fundamental or econometric analysis (or both)—fared quite well, with the biggest gains in market share amongst equity ETFs. 

Vanilla equity funds simply lost out. It’s not just that vanilla giant SPY had outflows of $5.6 billion. Even outside of U.S. large caps, vanilla funds lost $706 million market share in the remaining nine of the top 10 equity segments. Flows came to these strategic funds in two ways: by accretion and by import.

Well-established momentum and fundamental funds gained significant new assets, with market share increases of $442.6 and $425.5 million. Meanwhile, new multi-factor and technical-based ETF launches brought significant seed capital—the initial investment that launches a fund. In a climate where most funds launch with $2.5 million, seeds in the $100 million range are sure to grab attention. In September, Nationwide Fund Advisors—a new entrant to the ETF landscape that offers an econometric, or technical approach to indexing—launched three funds with over $100 million apiece.

This trend played out in the U.S. Total Market Equity segment, where Vanguard Total Stock Market ETF (VTI-US) lost market share to fundamentally-constructed iShares Edge MSCI USA Quality Factor ETF (QUAL-US), and to two momentum funds, iShares Edge MSCI USA Momentum Factor ETF (MTUM-US) and PowerShares DWA Momentum Portfolio (PDP-US). You can also see the launch of Nationwide Maximum Diversification US Core Equity ETF (MSDU-US). The table below shows all U.S. Total Market Equity funds with a market share change of $50 million or greater in September.

Aside from the outflows and resulting market share loss in Vanguard’s Dividend Appreciation ETF, strategic funds ruled the month in the U.S. Total Market Equity segment in September. U.S. Large Caps, Developed Markets Ex-U.S. Total Market, Emerging Markets Total Market, and the Global Ex-U.S. Total Market segments had similar results. September investors tipped the scales towards complex, strategic funds.

Bring Your Own Assets

Investors favored actively managed funds too, but parsing winners and losers in this space can be confounding, because many of the new entrants are old-line mutual fund providers looking to get into the ETF game. Often, these old-line players make a big splash, bringing sizable seed capital to their ETF launches.

This seed may represent new inflows for the issuer, but oftentimes it is simply transfer from existing mutual funds to new ETFs. Investors who make this move may benefit from a fee reduction and increased tax efficiency, but the issuer nets no additional assets. This is called cannibalization, and it is on the rise among asset managers looking to enter the ETF marketplace.

Cannibalization might be behind September’s active management market share gains. It turns out that half the market share pickup for actively managed ETFs was the result of a single new launch: Main Sector Rotation ETF (SECT-US), which came with nearly $163 million in seed capital. 

Funds seeded by cannibalization risk stalling out after the initial transfer. We often see this in the ETF landscape. Of the 10 successful actively managed funds launched during 2017 (assets of $50 million or greater at the end of September), four have not gained any assets beyond the seed capital, though in some instances the seed took a few weeks to trickle in. However, strong seeding is hardly a guarantee of continued success.

In fact, there’s a real tortoise-and-hare story among 2017’s active equity launches. The hare: Principal Active Global Dividend Income ETF (GDVD-US), which came out of the gate with about $450 million of seed capital. The tortoise: the Davis Select suite (DFNL-US, DWLD-US, DUSA-US), which launched in January with minimal assets but has grown steadily since then. 

Here’s what the hare’s flows look like, as of October 4, 2017:

And here’s one of the tortoises—specifically, Davis Select US Equity (DUSA-US):

It’s too soon to know whether SECT will be a tortoise or a hare, but it’s not too soon to recognize that both outcomes are common in the ETF space. To put this in perspective, GDVD lost over $10 million in market share in September, because it took in no new assets while its competitors netted over $600 million. The Davis suite gained $12.2 million of market share, by adding $13.4 million of inflows in September.

Expensive, Complex Funds Won September

Chalk one up for complexity. September’s excess gains in ETF market shares went to strategic funds and active management, at a high comparative cost—counter to 2017’s dominant trends so far. The weighted average expense ratio for strategic equity ETFs that gained market share in July was actually higher than the cost of strategic equity funds that lost market share—and significantly higher than their vanilla counterparts, both winners and losers. Ditto for actively managed funds. The table below shows weighted average expense ratios for equity funds by strategy, and by market share change, as of September 29, 2017.

 This is quite an impressive feat, especially for active management. In an ETF context, where every basis point matters, building market share for expensive funds is a huge accomplishment—and seems counter-intuitive to what we think we know about cost-conscious ETF investors. In September, the gap between penny-pinching vanilla investing and alpha-seeking behavior widened. It’s an interesting world out there.