There has been significant discussion within the ETF space regarding non-traditional indexes, which have been called many different names, including fundamental indexes, strategic indexes, strategy indexes and, most recently, smart beta. For those who favor a low-cost index approach to investing, the evolving terminology has made it difficult to understand what fits in the universe of index investing. While ETFs have a multitude of strengths, this is an area where ETF sponsors have done a disservice to index investors.
The path leading to this point began with the convergence of two components: the rapid growth of traditional index ETFs and the SEC’s review for approving transparent, actively managed ETFs. Many participants in the fund industry clearly recognized the attributes of ETFs. Prior to the introduction of the first non-traditional ETF offerings, more than 80% of equity mutual fund assets were in actively managed strategies. It was only natural that a more efficient investment structure combined with a continued strong investor appetite for actively managed strategies would drive the development of new innovative strategies. The only problem was a legal one since there was not yet regulatory approval.
As a result, forward-thinking ETF sponsors found what they believed to be a better way to get market exposure and introduced quantitative models that could be easily calculated into an index. The new products came in all shapes and sizes, including equal-weighted, fundamentally weighted and dividend-weighted among others that differed from traditional index ETFs. Time has proved those ETF sponsors right. According to Morningstar, at the end of 2013, these index strategies contained just under $300 billion in assets.
Regardless of the marketing name du jour for these indexes, the one characteristic all these strategies share is a passive portfolio manager. While most investors and advisors take comfort knowing that portfolio managers of traditional index strategies usually charge very low fees, the strategies in these new index ETFs charge considerably more. Although industry providers may indicate such ETFs don’t charge as much as actively managed mutual fund strategies, which on average is true, they are often justified by calling these index ETFs “hybrid active.” It would be incorrect to say these funds do almost as much work as managers of actively managed strategies. In fact, they do the exact same amount of work as any other index portfolio manager.