The Rise of ETFs Juiced by Smart Beta

The Rise of ETFs Juiced by Smart Beta

This week produced some market information which prompted a double take. The number of publically traded stocks in the U.S. has been surpassed by the number of exchange traded funds (ETFs). In 1995 there were 7,487 publically traded US stocks but this number has fallen by 42% to a little more than 4,000 companies. By comparison the number of ETFs has increased from 250 in 2010 to over 5,000 today!

What is behind these major changes in U.S. public markets? The shrinking number of public companies is partly explained by consolidation and merger activity of corporate America. In addition, private equity firms have been on a buying spree and the Dot-Com crash has likely also played a role.

Before discussing the recent growth in ETFs let’s be sure of what they are as investments. An ETF is a type of investment fund which owns underlying assets such as stocks, bonds, or commodities. The ownership of those assets is divided into shares which are marketable. Therefore, unlike a mutual fund, an ETF trades much like a common stock with price changes throughout a trading day. ETFs typically have more liquidity and lower fees than mutual funds.

The largest ETFs are generally those created to track the performance of the big market indexes such as the S&P 500 Index. The latter index represents the value of the largest 500 companies in America. It would have been difficult for investors to “invest” in all 500 companies prior to the creation of the ETF. In effect ETFs allow investors with very small amounts of capital to invest in an index and develop a diverse portfolio relatively inexpensively.

The explosive growth in the number of ETFs has been heavily driven by a number of factors including the poor performance and higher fees of active managers like mutual funds. Because of the underperforming mutual fund managers, there has been a massive movement of capital out of mutual funds into new ETF strategies.

While most ETFs are passive solutions intended to mimic an index, a new breed of ETFs have been branded as “Smart Beta ETFs”. These are ETFs designed and managed to achieve a certain goal such as generating dividends or income, or even making a levered bet on the direction of interest rates. These new ETFs enable investors to widen their investment choices to include making some fairly specific calls on the market.

Investors that have become disenchanted with traditional mutual fund managers have flocked to these smart beta ETFs. Of the $1.4 trillion now invested in lower cost “smart beta strategies” over $900 billion of the money came from more expensive mutual funds. Time will be the ultimate judge of whether the smart beta strategies are any good. One thing is certain, “smart beta” equals “smart marketing” to our country’s top ETF managers.

Carl Gambrell