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E xchange-traded funds (ETFs) are among the major beneficiaries of the highly electronic and liquid U.S. equity market--mostly trading more cheaply than their underlying stocks and typically tracking net asset values (NAVs) closely.
ARE ETFS REPLACING MUTUAL FUNDS?
Good tradability combined with low fees has helped U.S. ETFs grow to over $2 trillion in assets. In the past 8.5 years, U.S. equity ETFs have seen inflows of $604 billion (Exhibit 1). Ironically, withdrawals from U.S. equity mutual funds, at $742 billion, are roughly opposite.
Exhibit 1
U.S. Equity ETF Growth Has Roughly Offset U.S. Mutual Fund Outflows
Sources: ICI, Bloomberg (through July 31).
[Figure omitted. See PDF]
BETA TO ALPHA: AN INVESTOR CONTINUUM
The Investment Company Act of 1940 has allowed a variety of different investment vehicles--from ETFs to mutual funds--with index to active exposures. In fact, there is now almost a complete continuum between vanilla index ETFs and active mutual funds--with different trading and holding benefits for each product (see Exhibit 2). What is interesting in looking at this continuum is that active ETFs would fit between transparent active and closed-end funds, both of which are already approved for intraday trading.
Exhibit 2
Investment Universe Continuum from Index ETFs to Active Mutual Funds
[Figure omitted. See PDF]
Index, Size, and Style ETFs
Early ETFs were fairly classic index products, and to date, the majority of ETF assets remain in cap-weighted index ETFs (Exhibit 3).
Exhibit 3
New Listings of CEFs, Smart Beta ETFs, and Active ETFs
Note: CEFs have been around much longer, but new funds are more likely to be active or smart beta ETFs.
Source: Bloomberg .
[Figure omitted. See PDF]
After classic index funds came size and style ETFs. We consider these also to be classic index products because they merely subclassify the broader market and remain market-cap weighted.
Smart Beta ETFs
About a quarter of ETFs fall under the (broad) definition of smart beta, although many were created before the term was coined. We like the termsmart beta because smart implies something more dynamic and with higher turnover than a cap-weighted index fund, whereas beta implies something systematic, with no style drift or subjective inputs, and giving more predictable results than other active funds. It remains important, however,...