What investors can learn from the $1.7 trillion ETF market


The bull market in passive, index-based investing is as strong as ever, at least judging by the tsunami of money washing into exchange traded funds.

U.S.-listed ETFs attracted $188.4 billion in 2013, according to data compiled by Morningstar. That’s just a bit under the $190.1 billion these funds raked in back in 2012.

Over the last decade, the popularity of ETFs as relatively inexpensive investment vehicles to track broader markets or sectors is one of the more interesting trends in personal finance. Total ETF assets are now hovering around $1.7 trillion by Morningstar’s reckoning; equivalent to 13% of long-term mutual fund and ETF industry assets.

Move beyond the headline numbers and dig deeper into the data, and some interesting patterns emerge. The money that flows in and out of particular ETF sectors says a lot about the mindset of a broad swathe of investors. Here are three trends worth watching.

Smart beta or smart alpha?

One of the hottest ETF sectors right now is “smart-beta” focused funds, which ironically enough might actually suggest a bigger investor appetite for actively managed investments and alpha strategies than commonly assumed.

Here’s why: Many index funds are capitalization-weighted, anchored by the most popular stocks by market value. Truly passive investors accept the lineup of stocks, even if some are overpriced, that best reflects the index or asset class they want exposure in. In a rising market, this can be profitable. If the market tanks, watch out.

Smart-beta ETFs offer an alternative, according to recent post by John Wasik at Reuters. As he points out:

“A better alternative could be to own ‘smart-beta’ funds. While still built on indexes, the stocks within these baskets are often picked for their cash flow, book value, dividends and sales. That means instead of picking all of the potentially overvalued stocks that have won the market’s latest beauty contest, more fundamental measures are applied.

Generally, smart-beta funds emphasize large stocks with healthy dividends that may not be everyone’s favorite at the moment. Their portfolios may include a healthy dose of older, defensive and dividend-rich companies in manufacturing, utilities, healthcare and financial services.”

If that kind of sounds like an alpha-seeking strategy, well it kind of is. Reshman Kapadia at Barron’s recently wrote that choosing a smart-beta ETF is not unlike choosing an actively managed mutual fund. (Or portfolios that mirror a manager’s trade like those available at Covestor for that matter.)

“It’s really important to understand how the underlying index is constructed and what biases that may introduce into the mix,” John Feyerer, head of Invesco PowerShares’ product strategy & research team, told Kapadia. “No strategy is going to work in every market condition.”

How big is the Smart-beta sector? According to Morningstar’s analysis, there are now 249 funds with the smart-beta theme with assets of $277.9 billion. That’s up up from $179.1 billion a year ago. These funds, which attracted $46 billion in inflows last year, are enjoying a 26% growth rate.

Europe and Japan

These are two big economic comeback stories and investors seem pretty bullish on those recoveries continuing. Aggressive monetary easing by both European Central Bank and Bank of Japan have lit a fire under stocks markets across much of the Eurozone and Tokyo.

Enthusiasm for both stories helps explain why $19.3 billion flowed into foreign developed market ETFs tracked by Morningstar. That’s the most robust performance since a $12.8 billion inflow in 2007, before the European debt crisis.

Japanese and European-focused ETFs are among the best-performing funds in terms of incoming capital. Check out the organic growth rates of the Wisdom Tree Japan Hedged Equity (DXJ), iShares MSCI Japan (EWJ) and Vanguard FTSE Europe (VGK) ETFs.

ETF vs. mutual funds

Michael Rawson with Morningstar has some interesting observations about differences between ETF and mutual fund investors, in addition to other insights you can find here.

He notes that ETF investors “sold roughly $6.6 billion out of funds in the diversified emerging-markets category while mutual fund investors bought $39.0 billion” in 2013.

Why? One possible reason is that ETFs focused on emerging markets tend to be owned by institutional investors, who are more tactical and interested in market-timing. Mutual investors in this space are predominantly owned by individual investors with a longer view.

At Covestor, we have nothing against ETFs. They play a useful role in many portfolios. Our core investment philosophy is that passive and actively managed strategies can work together to help investors reach their financial goals.

Photo Credit: PeterJBellis

DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk, the amount of which may vary significantly. ETFs are subject to risk similar to those of stocks including those regarding short-selling and margin account maintenance. Past performance is no guarantee of future results.