VYM - Can Smart Beta ETFs Return To Prime Time?

2023-09-21 02:30:00 ET

Summary

• Active ETFs have scored more investor interest this year than smart beta ETFs - but does that mean the latter will soon be out of the game completely?
• For US-listed smart beta ETFs, inflows peaked in 2021 at almost US$150 billion.
• This year - which is now almost 75% in the books - smart beta inflows have not even hit US$20 billion.

By David Mann, Head of ETF Product & Capital Markets, Franklin Templeton

Active ETFs have scored more investor interest this year than smart beta ETFs - but does that mean the latter will soon be out of the game completely? David Mann, Head of ETF Product & Capital Markets at Franklin Templeton, opines.

I have been hesitant to put pen to paper for another exchange-traded fund ((ETF)) article considering that any topic would probably be disappointingly less fun than our recent Taylor Swift/ETF eras commentary .

During these occasional bouts of writer’s block, I always turn first to my wife for any suggestions or sage guidance on her part. She was in the middle of watching the latest episode of “60 Minutes” and before I could even seek her counsel, she asked, “Who is Deion Sanders, and what is going on with Colorado football?”

Okay! Starting with the second part of that question, the renaissance underway with the University of Colorado football team has been nothing short of astonishing. Last year, they won one football game. One!

This year they’re undefeated, ranked in the top 20 nationally, and have a road win over last year’s championship game finalist. Leading the team - and the reason there’s now a waiting list for season tickets - is their first-year head coach, Deion Sanders.

Nicknamed “Prime Time” for his confidence bordering on arrogance, Sanders has been a sports fixture in my life since the early 90s. He is a National Football League ((NFL)) Hall of Famer who won Super Bowls with both the 49ers and the Cowboys.

And, he also happened to play professional baseball for almost a decade. After retiring, he then had a long career as a sports broadcaster before entering the coaching arena in 2020 at Jackson State (hence: Coach Prime).

For decades, I’ve heard Sanders referred to as a two-sport superstar. But to me, that is not entirely accurate. I believe he is a generational NFL talent who also happened to be good enough to play professional baseball.

I can only speculate that when my wife asked me about Deion Sanders, she was wondering if his sports acumen had some implications to the recent slowdown in smart beta ETF demand.

I really did not appreciate the extent of the reduced inflows into smart beta ETFs until the topic was raised by Nate Geraci during my guest appearance on his “ETF Prime” podcast.

For US-listed smart beta ETFs, inflows peaked in 2021 at almost US$150 billion. That pace was almost matched in 2022 when a little over US$130 billion of new money went into smart beta ETFs. This year - which is now almost 75% in the books - smart beta inflows have not even hit US$20 billion. ¹

What exactly is happening here? It’s hard to guess, but I think smart beta may be “a two-sport superstar” (There it is! My Deion tie-in). I thought smart beta was presented as the perfect balance of active insights delivered in index form, but I think investors had a different sentiment:

• Active to those that wanted active insight, and
• Beta to those that wanted a low-cost index option other than market-capitalization weighted.

For investors who prefer the active management aspect, it is very possible that this year’s rise in active ETF assets has come at the expense of smart beta ETFs.

Active ETFs are on pace for their best-ever year of inflows in the United States, both in dollar terms (on pace for ~US$100 billion) and percentage terms (currently at ~25%). ²

The ETF Rule of 2019 codified that there were not any operational differences between active and index ETFs. I speculated that investors would steadily become more comfortable getting active exposure within the ETF vehicle post the passage of this rule, which does seem to be the case.

For investors who prefer the indexing aspect, smart beta ETFs are often compared to other index funds in the market, many of which have very low expense ratios.

For example, thus far in 2023, the top 50 index ETF asset gatherers have a weighted average expense ratio of 11 basis points. ³ It’s no surprise then that some of the better smart beta ETF asset gatherers are those with lower expense ratios - something I’ve seen firsthand with our own ETF lineup this year.

The idea of a perfect balance is nice, but it would not surprise me if, over time, investors gravitate to either active management or low-cost indexing. Will smart beta be the next story in ETF fee compression?

Looking out over the remainder of this year and into next year, I will be as fascinated to watch the Colorado Buffaloes as I will be to watch the push and pull continue between the active and index nature of smart beta ETFs.

What are the risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those offering potential for higher returns are accompanied by a higher degree of risk.

For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.

ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.

Commissions, management fees, brokerage fees and expenses may be associated with investments in ETFs. Please read the prospectus and ETF facts before investing. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated.

1. Source: Morningstar through September 15, 2023.

2. Source: Bloomberg. As of September 15, 2023.

3. Ibid.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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