Introduction
companies in the index.
4
At the most extreme levels of market share, passive ETFs would cause increased
market correlation and a breakdown in price discovery. However, we are still very far from that point. Passive
ETFs and passive mutual funds (which are actually a larger category) now hold 14% of S&P 500 company
shares and 17% of Russell 2000 company shares. This is up by >300% over the past 10 years. Robo advisors
and the implementation of fiduciary rules continue to drive advisor-managed funds into ETFs. Meanwhile,
institutional investors such as pensions and endowments are also jumping on the ETF wave. For example, John
Skjervem, the chief investment officer of the $90 billion Oregon State Treasury, recently commented on his
decision to move 15% of the pension’s equity portfolio into passive funds as well as on his long-term view that
up to 80% of the pension’s public stock and bond portfolio could end up in passive vehicles: “What’s going on is
a generational shift. Guys like me are moving in, and we had education that was empirically more rigorous than
the prior generation’s.”
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Estimated Holdings of Passive Funds in S&P 500 and Russell 2000
Sources: WSJ via FactSet, Bloomberg, Goldman Sachs
Active ETFs Proliferating—Risks Abound
As noted previously, ~40% of U.S. equity assets under management (AUM) are passively invested if we
include rules-based factor investing—which is really active investing without a human interface. The case for
truly passive ETFs is strong for unsophisticated long-term investors, but in the real world, ETF investing patterns
are not so rational. A growing portion of ETFs are not constructed to be passive market indexers but rather are
essentially active investors. If passive indexes improve efficiency by reducing fees and withdrawing money from
underperforming investors, active ETFs are likely to have the opposite effect. These fund flows tend to exhibit
performance-chasing patterns driven by backward-looking retail investors (and some advisors) rushing into the
latest “hot” ETFs. Chief among these are factor-based or “smart beta” ETFs.
4
Chris Dieterich and Corrie Driebusch, “Wall Street’s newest puzzle: What passive buying and selling means for individual
stocks,”
The Wall Street Journal
, September 21, 2017, https://www.wsj.com/article_email/wall-streets-newest-puzzle-what-
passive-buying-and-selling-means-for-individual-stocks-1505986202-lMyQjAxMTE3NjI1MjAyNDI1Wj/.
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Anne Tergesen and Jason Zweig, “The dying business of picking stocks,”
The Wall Street Journal
, October 17, 2017,
https://www.wsj.com/articles/the-dying-business-of-picking-stocks-1476714749?mod=djmc_pkt_email_092617
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Introduction
Popular investing factors that are isolated or combined into ETFs include momentum, minimum
volatility, value/growth, quality, dividend, and size (typically small-cap-biased). Many of these factors are
marketed based on academic research that document long-term excess returns or diversification as well as risk
reduction benefits. For example, low-volatility and dividend stocks materially outperformed during each of the
past two bear markets. However, these historical relationships are founded on varying degrees of strength and
fundamental soundness. There is a long-raging debate in both academia and the investment community over
whether the outperformance of factors such as value and small capitalization reflect appropriate compensation
for higher risk or anomalies of an inefficient market. Likewise, it remains uncertain whether these factors will
continue to outperform in the future (and their outperformance has diminished in recent decades). In fact, fund
flows into factor ETFs could be the mechanism for eliminating these historical anomalies.
Other ETFs that should be considered forms of active investing include sector ETFs and equal-weight
(EW) ETFs. The ease of investing in sector ETFs may be behind recent patterns of divergent performance
across sectors and could create sector bubbles. EW ETFs are actually thinly veiled active investment strategies
that style tilt to smaller companies. In fact, one of the largest EW ETFs, the Guggenheim S&P 500 Equal Weight
ETF (RSP), markets itself as “the first smart beta ETF.” By definition, the smaller the company, the more the EW
ETF is overweight (as a percentage of the company’s market cap or float). To a lesser extent, EW ETFs style tilt
toward anti-momentum and traditionally defined value stocks, as smaller and lower multiple companies are
more likely to be recent underperformers. Unlike market-weighted ETFs, equal-weighted funds also involve
active rebalancing, with potentially high portfolio turnover unless limited by rebalancing rules.
To help crystallize the distortive impact of fund flows into active ETF strategies with a theoretical
scenario for illustrative purposes: If $100 billion in S&P 500-tracking ETFs flowed into ETFs tracking the S&P
Equal Weight Index (or vice versa), Apple (the highest-weighted stock in the SPY, at 3.8%) would see selling (or
buying) pressure equivalent to just 0.5% of its float, or less than a day’s average trading volume. By contrast,
Patterson Companies (the smallest company in the S&P 500) would see inflows totaling 6.2% of its float if the
funds flowed into EW ETFs. Another ETF that exemplifies the risk posed by fund flows into both sector/industry
ETFs and equal-weight ETFs is the SPDR S&P Biotech ETF (XBI). This $4.4 billion ETF invests across 100
biotech companies using a modified equal-weighted index. As a result, this relatively modestly sized ETF alone
holds >3% weightings in some of the smaller stocks in the index. Speculative and momentum-driven investment
flows into or out of this ETF could cause valuation distortions and huge volatility in the share price of these
smaller companies.
Recent data suggest that active ETFs may have reached large enough scale that their market impact is
no longer theoretical. Last year, BlackRock projected that equity smart beta ETF assets would grow from ~$300
billion in 2015 to $1 trillion by 2020 and $2.4 trillion by 2025.
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ETF data from independent research firm ETFGI
suggests that smart beta asset growth has been even more rapid. As illustrated in the following chart, ETFGI
estimates that equity smart beta ETF/ETP assets reached $630 billion globally at the end of August 2017, with
76% of assets linked to U.S. markets. This represents 18% growth YTD from $533 billion at the close of 2016
and an astounding 5-year CAGR of 31.5%. This compares to a 21.3% 5-year CAGR for all ETF/ETP assets and
translates to a smart beta share of 18.6% of all ETF/ETP assets. ETFGI estimates that another $61 billion in
assets are in other actively managed ETF/ETPs that do not track any specific index.
6
BlackRock, “BlackRock projects smart beta ETF assets will reach $1 trillion globally by 2020, and $2.4 trillion by 2025,”
May 12, 2016, https://www.blackrock.com/corporate/en-us/newsroom/press-releases/article/corporate-one/press-
releases/blackrock-smartbeta-research_US
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