Active Management is Key Growth Driver in “Passive” ETFs

May 9, 2019

Looking for proof of the value of active management? Then check out the hottest trends in exchange-traded funds! Some of the strongest asset growth is in smart beta ETFs and other ETFs that incorporate an active management component.

Surprised? ETFs were once purely passive investments, mirroring well-established indexes to provide exposure to the broad market.

But today’s ETFs use quantitative security selection techniques, bespoke indexes and even fully active approaches to help investors enhance returns, access specific sectors of the market and customize portfolios to match risk preferences.

These new-style ETFs often combine active and passive investment approaches, providing investors with options than span the active management spectrum. 

In other words, the expansion in the ETF universe confirms what many of us have known for some time – that active management is an essential component of investor portfolios and that active and passive management work well together.

Here’s a quick guide to active management trends in ETFs:

Smart beta ETFs. Smart beta ETFs use quantitative techniques to construct the indexes that the ETFs are based on. According to a report in the Financial Times, they attracted $77.6 billion in assets in 2018 – with inflows 12.4% higher than the previous year. Smart beta ETFs now account for 1 of every 5 dollars invested in ETFs, for a total of $806 billion.

Smart beta ETFs combine elements of both active and passive management. They rely on active management judgment to develop a weighting or stock selection approach, but then apply this methodology predictably.

Many commentators view smart beta strategies as a hybrid between active and passive management. For example, Professor Russ Wermers of the University of Maryland, a noted expert on the securities markets, has called them “quasi-active.” Interestingly, because smart beta ETFs mirror an index (albeit one that selects securities using active management techniques), the major databases classify them as “index” rather than “active.”

Sector ETFs. Equity ETFs that concentrate on stocks in a specific industry or that are connected by common theme now account for almost 10% of total ETF assets, or $435 billion.

Just investing in these ETFs requires active decision-making, perhaps more so than for any other type of ETF. That’s because these focused funds are affected by specific industry trends and not just general market forces.

At the same time, the development of the underlying indexes is the often the outgrowth of an active assessment of investment potential rather than merely an attempt to capture broad market exposure. The indexes used may be constructed on a “bespoke” or custom basis specifically for the ETF.

Active ETFs. While active ETFs are still a very small segment of the market, with just $74 billion in total assets, it’s a segment that’s growing rapidly: active ETFs drew a record $27.5 billion in new investor assets in 2018, reports the Wall Street Journal.

Today, the active ETF segment is dominated by bond funds. That’s not surprising, since the distinction between active and passive management is less clear-cut in fixed income than it is in equity investing. Bond indexes often include a large number of securities, making it difficult for index fund managers to replicate them exactly. Instead, index fund managers in the bond space often rely on sampling techniques that incorporate some of the methodologies used by active managers.

Looking to the future, the interest in active ETFs is likely to continue to grow, as new “non-transparent” structures make it possible to offer ETFs in a wide range of asset categories.

The takeaway: The complexity of today’s investment universe means that there’s no clear dividing line between active and passive. Instead, there’s a full spectrum of investment alternatives – with each point from passive to active playing an important role.

Note: All asset figures from ETFdb.com as of March 10, 2019.