Five investment strategies propelling the rise of ETFs

Oct 8th, 2018 | By | Category: Alternatives / Multi-Asset

By Matthew J. Bartolini, Head of SPDR Americas Research.

Matthew J Bartolini, Head of SPDR Americas Research

Matthew J Bartolini, Head of SPDR Americas Research.

Investors were given a crash course in using ETFs during the financial crisis. Once they started implementing investment strategies with these funds, they never looked back.

While I’ve explored how efficient access to asset classes, particularly fixed income, helped drive the adoption of ETFs in the past ten years, so too has the increasing number and sophistication of ETF investment strategies. Here are five investment strategies that we believe have spurred ETFs’ explosive growth since 2008.

1) Asset allocation

Asset allocation is a critical component of any investment strategy, allowing an investor to allocate assets in a manner that meets their risk tolerance and return objectives. In 2008, as the financial crisis unfolded, there were only four asset allocation ETFs currently trading in the market. But that number is far higher today as investors became more comfortable with ETFs, and therefore ETFs that hold ETFs, leading asset allocation strategies to grow in number and complexity.

A considerable number of ETFs are now available to implement a wide range of strategies, from the basic tactical global allocation portfolio to the targeted income solution to the more complex long-short strategies. Multi-asset funds were also launched, allowing investors to pursue diversification strategies in a single ETF by allocating to a strategy that can hold everything from stocks, bonds and REITs to commodities and currencies.

Key takeaway: Today, the ETF wrapper provides investors with the ability to diversify existing holdings with alternative multi-asset strategies or offer a one-stop shopping solution for efficient asset allocation based on a client’s risk tolerance.

2) Smart beta

Smart beta existed in 2008, but not in the way we think of it today. Ten years ago, there was only a handful of smart beta ETFs. They held roughly $14 billion in assets spread across nearly 100 funds, with 54% of those assets invested in dividend-focused exposures.

Today, smart beta strategies have proliferated exponentially, and assets under management have soared to $365 billion spread across over 450 funds. But this wasn’t from increased usage in traditional dividend-related products. New factor-based strategies focusing on well-documented market premia, such as value and momentum, have gained market share.  As a result, dividend-focused funds now only account for 42% of today’s smart beta assets, and we have started to see smart beta applied to an expanded range of asset classes, like fixed income.

Key takeaway: This shift in buying behaviour indicates that over the last ten years, investors have begun to view portfolios through more of a factor lens. They are choosing among smart beta funds that provide specific exposure to a range of factors, including minimum volatility, momentum and size, or opting for multi-factor funds that offer exposure to multiple factors in one fund.

3) Environmental, Social and Governance (ESG)

In 2008, ESG investment strategies were mainly focused on the “E”—environmental investing—and not so much the social or governance aspects of ESG. Today, ESG investing has transformed and along with it, ESG ETFs. The number of ESG funds has expanded from 16 to over 70. Assets haven’t followed the product increase, however, as today there is only $8.7 billion in ESG ETFs compared to $4.6 billion in 2008. While a 50% increase is not terrible, it trails the adoption rate for the broader ETF industry over the last ten years.

What is interesting though is the type of products that have come to market. Today there is more sophistication in the construction of ESG funds. For instance, company data on a firm’s ESG practices can be leveraged to weight securities in an index, or an end exposure can be optimized to ensure there is tight tracking error to a flagship, standard market-cap weighted benchmark.

As an example, we launched our SPDR SSGA Gender Diversity Index ETF (SHE US) in 2016. SHE tracks the SSGA Gender Diversity Index, an exposure that leverages company information to appropriately weight US large-cap firms with a more gender-diverse leadership structure relative to their sector peers.

Key takeaway: Products are proliferating as fund managers introduce ETFs allowing investors to align portfolios with their values—whether that’s climate change, corporate governance or gender inclusion—while still being able to focus on their financial goals and investment policy statements. The slower-than-market adoption rate is likely a byproduct of education on the role ESG strategies play in portfolios, a topic we routinely discuss with investors when building portfolios today.

4) Active

In this series, I’ve explained how the rise of ETFs is not merely being driven by investors’ preference for passive, index-based strategies. For instance, since 2008, sector ETFs have taken in 344% of their starting asset base. While sector ETFs may be considered “passive” funds, they are used by investors to implement tactical sector allocation strategies. Investors are going active using passive vehicles.

We have also seen an expansion of actively managed ETFs. Actively managed ETFs now number more than 240, and they hold more than $60 billion in assets under management (AUM). That is up from four funds in 2008 that held $300 million in AUM. That is an astronomical 18,167,607,644% increase in assets! This growth makes sense when taking a step back, as active management can be beneficial in market segments that are more inefficient or less liquid.

The SPDR Blackstone / GSO Senior Loan ETF (SRLN US) is an example of an actively managed ETF that operates in a market—senior loans—that can be inefficient and have low levels of liquidity in the underlying securities. SRLN’s active management allows it to focus on credit selection to avoid a weak or failing senior loan that might be included in a passive strategy.

While underlying loans have an extended settlement cycle, SRLN’s active managers can use their experience in trading and scale in the loan market to short settle if necessary to adequately meet redemptions. There is also more flexibility afforded in an active strategy in a market like this, as SRLN also holds roughly 7% in cash and 4% in high yield bonds to assist in managing daily liquidity.

Key takeaway: Actively managed ETFs provide the benefits of the ETF wrapper—improved transparency and increased liquidity—with the additional benefit of a manager who can adapt to shifting market conditions. Cost structures differ as well when comparing to actively managed mutual funds, as the average expense ratio for active mutual funds is 1.12% versus 0.65% for actively managed ETFs.

5) Low cost

In 2008, only 10% of assets were invested in what we would consider low-cost ETFs. However, low-cost ETFs now account for 40% of the US-listed ETF marketplace. After taking in 57% of all ETF flows in 2017, they are on track to attract nearly 80% of all flows in 2018.

Today’s low return expectations mean investors are keeping a closer eye on fees as they strive to meet their investment goals, and one place investors are putting an emphasis on keeping costs low in a portfolio’s core.

Key takeaway: Investors realize that costs matter and can accumulate over time, eroding a portfolio’s total return. Constructing a well-diversified, low-cost core can provide the support needed to pursue specific investment goals.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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