Active vs. passive? Why active ETFs face competition from ‘quasi-active’ smart beta funds in U.S. stock market

Hi! This week’s ETF Wrap digs into “smart beta” ETFs. It’s an area of the exchanged-traded fund industry that saw “significant inflows” last year and has “blurred the lines between traditional active and passive investing,” according to CFRA’s Aniket Ullal.

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Exchange-traded funds that are actively managed face competition from so-called smart beta ETFs as active managers seek to win over investors in an industry dominated by passive funds.

“‘Smart beta’ ETFs have blurred the lines between traditional active and passive investing,” said Aniket Ullal, head of ETF data and analytics at CFRA, in a recent research note this month. To keep expanding assets, he said active ETFs will need to take market share from smart beta funds.

Smart beta ETFs are “quasi-active” and have more equity assets under management than actively-managed ETFs in the U.S., according to Ullal. They also tend to be less expensive than actively-managed funds, he said in a phone interview.

“Essentially, a lot of the strategies that were employed by active managers in the mutual fund world got put into an ETF wrapper in a smart beta format,” Ullal said by phone. “People moved away from the mutual funds and into the smart beta ETFs.”

Assets in the U.S. exchange-traded-fund industry remain dominated by passive ETFs tracking broad market indexes such as the S&P 500
SPX
that are weighted according to the capitalization of companies, or their market value, according to Ullal. Passive funds targeting individual sectors in the stock market also are well-established, he said. 

The first ETF listed in the U.S., the SPDR S&P 500 ETF Trust
SPY,
was launched 30 years ago in January 1993. It had around $372 billion of assets under management as recently as Wednesday, according to FactSet data.

While smart beta funds are also linked to indexes, they’re distinct from traditional passive investing because they follow a set of rules, said Ullal. Those rules are designed to give investors exposure to investment factors, such as “quality” and “low volatility,” or themes such as “natural resources” and “infrastructure” that stretch across various sectors, he explained.

“Smart beta factors tend to go through cycles based on the environment,” said Ullal. “Now that we’ve seen more volatility in the market,” he said more defensive factors such as low volatility, value and dividends have gained popularity.

In his note, Ullal wrote that “smart beta factor investing received a boost in 2022,” as factors including dividends, value, and low volatility “significantly outperformed the broader U.S. equity market.”  

A chart in his report highlighted the 2022 total returns of the iShares Select Dividend ETF
DVY,
Invesco S&P 500 Pure Value ETF
RPV,
Invesco S&P 500 Low Volatility ETF
SPLV
and Invesco S&P 500 Pure Growth ETF
RPG
relative to the SPDR S&P 500 ETF Trust
SPY.
 


CFRA RESEARCH NOTE DATED JAN. 12, 2023

Smart beta ETFs represented more than 16% of equity assets in the U.S. exchange-traded-fund industry at the end of 2022, after attracting “significant inflows” last year, the note shows. That compares with a market share of around 3% for actively-managed equity ETFs, a fast-growing corner of the market based on data presented in the CFRA report. 

CFRA RESEARCH NOTE DATED JAN. 12, 2023

More than 50% of filings made with the Securities and Exchange Commission for new exchange-traded funds in the last quarter of 2022 were for active ETFs, according to the note.

Active funds are not linked to an index. Portfolio managers of actively-managed are making discretionary investment decisions, unlike smart beta ETFs, which are tied to indexes adhering to rules. 

For example, the Invesco S&P 500 Low Volatility ETF follows an index based on a rule that says it will hold 100 stocks in the S&P 500 with the lowest volatility, Ullal said by phone. And the ETF holds every stock in proportion to its volatility, meaning the lower the volatility of the stock, the higher its weight in the fund, he said.

The evolution of the ETF industry has made the view that investors have a “binary choice” between active and passive funds “too reductionist,” according to his note.

“Many of the indexed-linked ETFs launched in the last 10-15 years are not truly ‘passive’ products,” he wrote, as “they do not merely track broad, market-cap weighted indices.”

The success of active funds relative to “indexed, ‘quasi-active’ smart beta ETFs will be an important trend to watch in 2023,” he said in his note. 

But in his view, traditional passive funds such as the iShares Core S&P 500 ETF
IVV,
Vanguard S&P 500 ETF
VOO
and iShares Russell 2000 ETF
IWM
are not imperiled by the rising number of actively-managed ETFs.

“Truly passive low cost ETFs like IVV, VOO, and IWM, which are core holdings, have significant asset gathering momentum that will not be impacted by the launch of active ETFs,” he wrote. 

As usual, here’s your look at the top- and bottom-performing ETFs over the past week through Wednesday, according to FactSet data.

The good…
Top Performers

%Performance

ARK Fintech Innovation ETF
ARKF
5.6

ARK Genomic Revolution ETF
ARKG
5.1

ARK Next Generation Internet ETF
ARKW
4.7

KraneShares Global Carbon Strategy ETF
KRBN
4.5

Invesco WilderHill Clean Energy ETF
PBW
3.9

Source: FactSet data through Wednesday, Jan. 18, excluding ETNs and leveraged products. Includes NYSE, Nasdaq and Cboe traded ETFs of $500 million or greater

…and the bad
Bottom Performers

%Performance

United States Natural Gas Fund LP
UNG
-9.4

KraneShares CSI China Internet ETF
KWEB
-4.4

Utilities Select Sector SPDR Fund
XLU
-3.6

iShares U.S. Utilities ETF
IDU

-3.5

Fidelity MSCI Utilities Index ETF
FUTY
-3.5

Source: FactSet

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