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Growth of ETFs Is Not the Growth of Passive Investing

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Time and again, news articles emerge about the growth of ETFs that indicate investors are embracing low-cost, index-based passive investing. However, the popular perspective may not be the perspective with the most prudent consideration.

The ETF investment structure itself delivers many great features, and advisors and investors alike have undoubtedly embraced and gravitated toward the freedom and flexibility ETFs provide. Not too long ago, clients could only invest in mutual funds, which limited the number of exchanges and redemptions that an investor could make in a single year. Additionally, mutual funds charged high fees for what their sponsors deemed a “short-term” redemption.

Based on assets under management alone, ETFs are a success story; first with institutional investors, then with self-directed investors and financial advisors. Perhaps one of the more interesting aspects of this story is that some of the largest ETFs have displaced some of the largest stocks as the highest volume-traded securities on a stock exchange. Taking a closer look at recent data on the top 10 index ETFs, the total value of that ETF range shows turnover in trading anywhere from 10 days to 241 days (see table below). The top 10 ETFs by AUM — which represent one-third of all the AUM within the ETF space — on average experience turnover every 23 ½ days.

Top 10 ETFs by AUM

That astounding trading volume does not necessarily represent investors’ embrace of indexing and passive investing as much as it does ETFs’ flexibility. The notion that investors are rejecting higher fee, active management is not as evident. Based on the trading volume associated with the most popular ETFs, a different prevailing wisdom would indicate that active investment decisions are clearly a high priority in their usage. Even with fees, to suggest investors are demanding lower costs remains murky considering the transition of costs to commission and spreads, with active management decisions driving the use of index-based ETFs. The proliferation of smart beta, or custom-indexed ETFs, demonstrates a desire to add more value to an investment portfolio. Active ETFs will continue to grow, but likely not exponentially until larger firms armed with marketing and sales teams bring their best strategies to the ETF space.

Declaring that index ETF growth demonstrates the growth of passive management promotes an incomplete narrative. Astute advisors who have embraced the use of ETFs understand this more comprehensive ETF landscape through their own practice management — whether they are on the playing field making active investment decisions for their clients or outsourcing those decisions to portfolio managers. Ultimately, focusing on the why will illustrate that investor desire for freedom and flexibility has been the driving force behind the growth of the entire ETF space.