In focus - Thought Leadership

The unforeseen consequences of alternative equity index ETFs

Exchange-traded funds (ETFs) have democratised alternative approaches to passive equity investing. However, the shift in investor preference for alternative index strategies over broad market strategies may be storing up trouble.

04/03/2019

Sean Markowicz

Sean Markowicz

Strategist, Research and Analytics

The popularity of alternative approaches to passive index investing through exchange-traded funds (ETFs) has grown rapidly over recent years, overtaking traditional capitalisation-weighted strategies. Although the share of US equity securities held by alternative equity index ETFs is only 7%1, they account for two-thirds of total ETF assets. This is raising concerns that passive trading is having an impact on market behaviour. We analyse the evidence for these concerns and argue that if the tide of money suddenly reverses, this could worsen a market drawdown.

Renewed interest in alternative approaches to passive index investing has spawned hundreds of new ETFs. There are now over 700 ETFs tracking indices with a sector-bias or a methodology driven by some fixed rule other than simple market capitalisation. Recent flows data suggests that these alternative equity index ETFs are even more popular than traditional broad market capitalisation-weighted ETFs that track established market benchmarks such as the S&P 500 Index. Alternative equity index ETFs include sector, smart beta and thematic strategies. Over the past five years, about US$6 in every US$10 that has flowed into US equity ETFs has gone to alternative equity index strategies, boosting their share of assets to 64% of the total US equity ETF market (Figure 1).

Figure 1: Investors have preferred to invest in alternative index strategies

Broad market ETFs are defined as any ETF that tracks a capitalisation-weighted index covering at least 75% of the free float-adjusted market capitalisation in the US. Source: Bloomberg and Schroders. Data as at 6 December 2018. Based on physicallybacked, US-listed ETFs with the US as the geographic focus (excluding leveraged or inverse products).

Smart beta ETFs have attracted the most inflows and last year hit a record US$1 trillion in assets under management.2 Smart beta strategies attempt to outperform the market, or enhance a portfolio in other ways, such as reducing volatility, by systematically selecting, weighting and rebalancing portfolio holdings on the basis of fundamental characteristics such as valuation or company size. The underperformance of US active managers in recent years has arguably fuelled interest in such alternative index strategies. Yet, investors have not been rewarded by this trend. Over the past five years, alternative index ETFs returned on average 9.8% per annum, while traditional broad market ETFs returned 10.5% per annum (Figure 2).

Figure 2: The performance of the most popular alternative index ETFs has lagged behind the market

For comparison, the S&P 500 Index returned 11.1% per annum over the past five years. Source: Bloomberg and Schroders. Data as at 6 December 2018. Based on physicallybacked, US-listed ETFs with the US as the geographic focus (excluding leveraged or inverse products). Returns calculated using asset-weighted total returns over the past five years. Other ETFs include multi-factor strategies, minimum volatility strategies, momentum strategies and thematic strategies.

 

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1 Source: Bloomberg and Schroders. Data as at 6 December 2018.
2 Source: Bloomberg and Schroders. Data as at 6 December 2018. Based on physically-backed, US-listed ETFs with the US as the geographic focus (excluding leveraged or inverse products).

 

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