ETF Capital Markets Desk: Smart Beta, Small ETFs and Other Trends to Watch in 2019

David Mann

David MannHead of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments

It’s that time of year again where the pundits make their predictions on where they think the market is headed next. David Mann, our head of Capital Markets, Global Exchange-Traded Funds (ETFs), isn’t throwing his hat in that ring, but will offer his thoughts on some trends he sees taking shape within the ETF industry in 2019.

This is the now the third iteration of my New Year “predictions” posts. (Here are my 2018 and 2017 posts if you’d like to revisit them.)

While you will not find a prediction on where the 10-year Treasury yield or S&P 500 Index will be a year from now on these pages, I can tell you in that “new ETF regulations” did not make my list of 2019 industry predictions. However, I think it would be foolish not to incorporate some of the current market sentiment into my three ETF-specific calls this time around.

Without further ado, here are my predictions for 2019.

Smart Beta ETF inflows will finally break $100B for the year

Much has been written about the growth of smart beta ETFs, both broad trends such as new asset managers entering the ETF space as well as specific fund breakdowns highlighting their unique methodologies.

It feels like these smart ETFs are getting more popular, but that has not really been proven out when you look at the investment flows. Just look at the last five years: 2014: $63B, 2015: $71B, 2016: $56B, 2017, $78B.1 As of this writing, 2018 has seen $84B of smart beta inflows.2

I think 2019 will be the breakthrough year. Why, you may ask? Lots of reasons:

  1. Given the choppy markets we have seen recently, many smart beta ETFs have outperformed (sometimes significantly) their market-cap equivalent ETF. Even if many of them are not necessarily designed to outperform, strong performance can only help, right?
  2. The new ETF Rule. Yes, I know I said that I was not going to discuss regulations, but the proposed ETF Rule specifically acknowledged that structurally there is no difference between active and index ETFs. You can add smart beta as well.
  3. Increased questions about passive indexes. I recently read a very interesting academic research paper titled “Passive in Name Only: Delegated Management and ‘Index’ Investing.” This part stood out to me:

“Rather than being passive in any meaningful sense, index investing simply represents a form of delegated management. Instead of being truly passive, tracking an index almost always implies choosing a managed portfolio. Not only are these indices managed portfolios in the strictly financial sense, by their construction they imply a substantial amount of delegated decision-making authority.”3

I have previously discussed the blurring of the lines between active and passive and index ETFs. As an example, the aforementioned paper mentions how many index methodology changes the most common “passive” indexes have had over the past few years. It was eye-opening. As investors realize that smart beta is simply a different set of rules than one tied to a mechanical application of market-capitalization, the allure of “passive” market cap indexes should decrease.

We will see increased number of large trades in smaller ETFs. 

As we have discussed in these pages, we have been very pleased with investors’ understanding of the best practices for trading ETFs. More and more investors know that an ETF’s average daily volume does not tell the whole story and the liquidity of the underlying basket can be leveraged to trade much larger notional amounts.

The data proved that to be the case in 2018. There were 287 ETFs that had assets under management (AUM) between $25 million-$100 million and an average daily volume of over 10,000 shares per day.4 We feel this lower-AUM group should be a good indicator for ETFs that are smaller but are starting to gain attention.

Of those 287 funds, 136 (47%) had at least one trade during the year of over 10x its average volume. To repeat, almost half of these lower AUM funds had at least one trade over 10X its average volume! There are numerous examples of larger trades in smaller funds at many multiples of their average volumes, often within the bid/ask spread.

For 2019, I think this trend will continue. Our prediction is that when we run the numbers again, more than 60% of such funds will have at least one trade of 10x its average volume.

Something is going to go bump in the night.

Every so often, there is an article on how ETFs are going to cause some sort of market chaos. I am not going to list all of those here but can put them into two main buckets:

  1. Concerns on the ETF structure (for example, what if there were sudden mass redemptions?)
  2. Concerns on ETF trading (for example, what if market makers stepped away?)

I am not too concerned about the ETF structure. It has handled all sorts of market cycles and periods of heightened volatility and of these outcomes, I believe it will continue to do so, no matter how the markets behave in 2019.

I cannot quite say the same for ETF trading. The original ETF flash crash was in 2010. We had another one in 2015. Following those two events there have been some welcome regulatory additions such as Limit Up/Limit Down (LULD) that help limit the potential damage. The key word there is limit—when an investor wants to sell, an ETF trading 3% below the value of its basket is certainly better than 20%, but neither of these outcomes should leave him or her happy.

Really, we are debating the extent of the disconnect between the price of the ETF trade and where it could have occurred if all market participants were watching and ready. We have seen trades occur first thing in the morning before the markets have settled occur 50 basis points (bps) higher/lower than we would have expected. That is not going to cause any ETF halts, but it still stinks IMHO. A broader discussion on tighter bands for ETFs will be saved for another day.

Markets have wobbled a bit recently and many major stock indexes are now down on the year.

Although volatility has been increasing, the down days have been quite orderly for the most part. I am not surprised that ETF trading has been largely business as usual as trades are usually quite smooth during days of heightened volatility. What we have not seen is a heightened day of uncertainty.

Uncertainty happens when market participants are unsure of either a) the price of the ETF’s underlying basket or b) the price of correlated instruments such as equity index futures. We saw that occur in prior flash crashes mentioned above, where one had a severe intraday drop in the S&P 500 Index futures while the another had a huge overnight drop in several index equity futures prior to the US stock market open. In both case, it cast doubt on the actual value of the ETF.

When there is uncertainty, market participants will want to reassess their ETF valuations and will either widen their quotes or step away altogether. Investors who attempt to trade during those times could end up with a bad experience as was the case in 2015 even though it may now be to a lesser extent.

A moment of high uncertainty will come again and when it does, I fear we are going to be revisiting all the same discussion and commentary on how it could have happened and who is to blame. Just make sure that you are not the one trading when it does!

David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

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1. Source: Bloomberg, data as of December 31, 2018.

2. Ibid.

3. Source: Robertson, Adriana, “Passive in Name Only: Delegated Management and ‘Index’ Investing,” (November 2018). Yale Journal on Regulation, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3244991

4. Source: Bloomberg, as of 12/06/18.