ETF Evolution

Exchange-traded funds (ETFs) are investment funds traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day.
Low costs, relative tax efficiency¹, and portfolio transparency are well-known drivers of the rise of ETFs in recent years – but innovation is another secret of the ETF market’s growth
Passive investing is no longer simply a mirror to the market – a range of more sophisticated strategies are now available
The rising popularity of “smart beta” investing reflects the view that market-weight indexing² may fail to capture the full range of potential opportunities available in the marketplace – and that new strategies potentially can capture more of those opportunities

Exchange-traded funds (ETFs) are here to stay. Combining the tradability of stocks with many of the characteristics of diversified mutual funds, ETFs have increased assets under management by more than 25% a year for a decade – today managing more than $2 trillion in the US.³ As these figures illustrate, more investors are taking advantage of the structure’s low costs, tax efficiency, portfolio transparency, and intraday trading.

There is, however, another secret to the field’s rapid growth: Innovation. ETFs today offer some of the most innovative investment strategies on the market– a fact which we believe is fundamental to their rapid growth.

More than Mirroring the Market: How Passive Investing Has Changed

ETFs have been an important part of what is often termed the “democratization” of investment management – meaning the greater availability of once-exclusive investing techniques to a wider range of investors. ETFs today represent a vibrant and diverse array of investment strategies. Although the structure is often closely associated with passive, market-weight investing (meaning strategies which apportion their investments according to individual securities’ market values), ETFs can offer more than these market-weight investment approaches.

The growing field of “smart beta” illustrates the trend. Sometimes called “strategic beta” or “fundamental indexing,” these strategies are passively managed, but their results may differ versus market-weight indexing. That is because “smart beta” strategies shape the weighting of individual portfolio holdings differently than passive market-weight indexing.⁴ It does this in pursuit of a specified investment goal or set of investment goals. Because of this differentiated approach, smart-beta strategies are often compared to active management.

What do smart-beta strategies look like?

Smart beta ETF's represent 20% of US-listed AUM, but 41% of 2013 flows and 25% of 2014 YTD.

Source: Goldman Sachs Asset Management, based on Morningstar Strategic Beta classifications; of as 12/31/14.

Low-volatility⁵ investing and the pursuit of stocks exhibiting price momentum are two common “smart beta” goals, but many strategies pursue multiple goals. ETFs pursuing multiple goals are sometimes labeled “multi-factor.” They may, for instance, seek out a combinations such as (1) value or low-priced stocks, (2) stocks which exhibit low volatility, (3) stocks which demonstrate strong momentum (meaning a security’s tendency to show continued movement in a given direction, generally as measured by price), and (4) stocks which show a quality bias (meaning companies with strong balance sheets). Combining the pursuit of several goals is potentially one means of pursuing stronger risk-adjusted returns than market-weight indexing.

In a sign that investors see the benefits, assets under management in the US “smart beta” field have risen by a compound 33% rate over the last five years.⁶ Today, close to one-fifth of US equity ETFs can be classified as “smart beta.”⁷

Why do investors choose these strategies?

Besides features such as low costs and intraday liquidity, we believe that the pursuit of differentiated returns is a key consideration. Many investors believe that market-weight indexing fails to capture the full range of potential opportunities available in the marketplace – but that smart beta potentially can capture more of those opportunities.

One Solution, Many Innovations

ETFs are finding roles in a growing number of investment strategies. Global tactical asset allocation is one example. Global tactical asset allocation can be defined by the effort to seek improved risk-adjusted returns compared to passive investing through active adjustments to investment positions. ETFs have become an important tool in this innovative field because they can offer a variety of investment exposures, from broad markets to specific sectors and specialized investment strategies.

We believe that the variety of asset-class exposures which have been developed in ETFs is another illustration of the market’s history of innovation. Although equity strategies drive the most popular ETFs and represent the asset class for the first ETFs originated, about one-quarter of the roughly $2tn US ETF market today consists of exposures other than equities – a testament to the range of investment strategies available as ETFs.⁸

In several cases, ETFs have been credited with opening investment exposures to a wider range of investors. Starting in 2004, ETFs brought tradable and liquid access to spot gold prices to the average investor, who previously might have traded futures contracts or owned physical gold in search of this exposure.

In other cases, ETFs were useful market-access tools for asset classes which historically had presented fewer investment options for many investors, such as high-yield bonds, when compared to widely accessible markets, such as large-cap US equities. We believe the evolution of ETF investment strategies also reflects the diversity of market participants.

One Market, Diverse Participants

Although ETFs are commonly associated with individual investors, the reality is that the ETF market has been diverse from the beginning. The earliest ETFs, developed in the 1990s, derived much of their initial trading volume not from individual investors but from hedge fund traders, many of whom adopted ETFs as low-cost market access tools and trading vehicles. This legacy continues today, with hedge funds and institutional investors remaining active participants in the market.

As evidence, today more than half (56%) of reported ETF holdings belong to institutional investors, with individuals and small institutions (i.e., those with AUM of less than $100mm) comprising the remaining 44%.⁹

The type of institutional investors active in the market range widely, from pension funds to government entities.

Sovereign wealth funds sometimes deploy ETFs for liquid access to a range of markets, from US equities to gold and other assets.

Traditional asset managers have also found uses for ETFs, for instance in managing cash or in carrying out asset allocation strategies.

Pensions and endowments sometimes use ETFs to transition portfolios, manage cash flows or hedge unwanted exposures. A growing number of insurance companies have also turned to ETFs to hedge variable annuities, manage investment exposures or find alternatives to the derivatives markets.

Another participant group of note is financial advisors, who are turning increasingly to ETFs for their low costs, relative tax efficiency and variety of strategies.

The wide range of participants in the ETF market simply serves to underscore that the structure has proven itself adaptable to a wide range of investment needs.

ETFs: What the Future May Hold

As investors’ needs have evolved, so, too, have ETFs. At Goldman Sachs Asset Management, we believe the future of ETFs can combine the low costs, intraday liquidity and tax efficiencies for which ETFs are known with a fuller range of investment strategies – strategies which we believe potentially can capture more of the opportunities presented by today’s marketplace.

Topics: Equities

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ETF Evolution: The Innovation of Exchange-Traded Funds

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