What's Next for ETFs: More Choices, or Less?

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CHICAGO -- Many people think that investing should be exciting. I couldn’t disagree more. If you or your clients are enjoying investing, then you may be repeating the fear and greed cycle of buying high and selling low. As I say a few thousand times a year, I think investing should be dull.

So I was a bit nervous as the three giants of the ETF industry -- Blackrock's iShares, Vanguard, and State Street -- discussed their future at the Morningstar conference last week. I braced myself to hear about "new and exciting" ETFs like different alternative or triple-levered inverse funds. I can't believe I made it through the whole session without hearing such nonsense.


When moderator Ben Johnson of Morningstar asked about "Smart Beta," or what Morningstar calls strategic beta, State Street's Michael Arone and BlackRock's Matthew Raynor agreed that factor investing has a role.

But Vanguard's Doug Yones argued that varying from market cap is essentially taking a bet. Factor weighting is betting on styles and sectors to create a lopsided investment portfolio. State Street's Arone strongly disagreed: "Who's to say that market cap weighting is the right exposure?"

Yet weighting by past performance might not get you to your goal. Yones pointed to Vanguard research showing that new alternatively weighted ETFs bested cap-weighted ones looking backward before being launched, but not going forward. I personally have never seen a new product being launched that failed on a back-tested basis.

Yones acknowledged the validity of factor investing, but said investors must be committed as factors can underperform for a long time.

According to BlackRock's Raynor, who said his firm does far more than backtesting when launching a new fund, academic research shows there are only about a half dozen factors that appear to work over time. Those strategic betas include factors like size, value, momentum, and yield.

Missing in the discussion were two critical points. First is whether or not factor investing is a free lunch or compensation for taking on more risk. I'm with Eugene Fama and Ken French that it's the latter and that the additional risk isn't always measured by standard deviation.

Second is that only market-cap weighted indexes guarantee that the investor must outperform active as Nobel Laureate William Sharpe proved. Factor investing is taking bets that may or may not pay off, but will certainly create more costs and lower tax-efficiency.


When Johnson quizzed the panel on advisors' active use of passive funds to outperform the market, the responses were generally muted. I suspect the fund sponsors didn't want to offend the advisor distribution channel. In my view, using ETFs tactically is a fool's game since one tactical asset allocator selling an asset class must be bought by a different tactical asset allocator. 

So will active ETFs be the future? While Yones said active ETFs are likely to become much larger, BlackRock's Raynor said the firm is moving slowly as it looks at active ETFs.

Meanwhile, State Street is partnering with others to deliver more active ETFs, Arone said. He likened the tax-efficiency of ETFs combined with the best of active management to combining peanut butter and chocolate for an even better candy. Personally, I like Reese's Peanut Butter Cups better than active ETFs.

But looking at ETF 3.0. and what ETFs will look like in 10 years, Morningstar's Johnson said he believes at least 80% of ETF assets will still be in dull, broad index funds.

Arone sees fragmentation with different partnerships ahead. Raynor, who agreed, noted that the foundation and core portfolios must be key. More than 80% of cash inflows are still going into cap-weighted, boring funds, Yones pointed out. The future will see innovation in fixed income as varied from the market as any advisors want, he said, but investors should ignore the marketing noise. 

I left very pleasantly surprised that the three giants of the ETF space were more concerned about earning market returns and avoiding foolish behavior than introducing new hot products.  It was a very boring session and I couldn’t be happier.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for The Wall Street Journal and various AARP publications, and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.

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