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Seeking downside protection, investors show interest in actively managed ETFs

  • Migration to passively managed funds continues apace, but rising interest rates and increased market volatility is leading to a concurrent move away from pure indexing.
  • Actively managed ETFs and smart beta funds are both seeing growth.
  • Some product manufacturers are creating their own indexes for funds to track.

One of the strongest trends of this 10-year bull market has been the shift to passive investing. Trillions in assets have flowed out of actively managed mutual funds and into passively managed exchange traded funds and indexed mutual funds.

Last year was no exception, with just under $7 billion flowing out of actively managed funds, and $692 billion flowing into passively managed funds, according to year-end figures from research firm Morningstar. Only the popularity of actively managed bond funds, with $179 billion in inflows, saved active management from a third straight abysmal year.

ETFs are traded on exchanges, so they can be bought and sold like stocks through a brokerage.
Tetra Images | Getty Images
ETFs are traded on exchanges, so they can be bought and sold like stocks through a brokerage.

With interest rates rising and volatility up in the markets, however, investors may be shifting away from pure indexing toward more active management of investment risk.

"It's about downside protection," said Ryan Sullivan, a vice president of global ETF services at Brown Brothers Harriman. Sullivan helps fund companies to design and administer their products.

"There seems to be a growing interest in actively managed equity products in an ETF wrapper," he said.

Actively managed ETFs, where portfolio managers pick and choose investments like active mutual fund managers instead of simply tracking an index of assets, have been growing rapidly, albeit from a very small base. The lion's share of assets in the space is in fixed-income funds employing total return or low duration strategies.

"It's taken time for active management [in ETFs] to gain traction in the market," said Sullivan. "The segment has continued to set records in terms of growth, but it still represents only 1 percent of the broader market."

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That may change this year, judging by the results of a recent survey of financial advisors and institutional investors by BBH. The survey found a big increase in interest in the products, particularly in the area of international equity and emerging markets, which attracted $239 billion in fund flows last year, per Morningstar.

To that point, 54 percent of survey respondents said they would use actively managed ETFs in emerging markets, and 45 percent said they would do so in international developed markets.

"I think we may see a spike in demand for actively managed ETFs this year," Sullivan said.

The explosive growth in so-called smart beta funds also suggests investors are not as comfortable buying the market or segments of it through simple indexing. Assets in smart beta funds surpassed $1 trillion in December and now comprise about one quarter of the entire ETF market.

The funds still passively track an index, but they use a rules-based methodology to screen a universe of securities for desirable factors, such as profitability, high dividends, low volatility or value for equities. In the fixed-income market, popular factors to emphasize include credit quality, yield and duration.

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Some product manufacturers are taking things a step further and creating their own indexes for funds to track. Last summer BlackRock, the world's largest asset manager, launched some fixed-income ETFs — specifically, the iShares Edge Investment Grade Enhanced Bond ETF (IGEB) and iShares Edge High Yield Defensive Bond ETF (HYDB) — that track a proprietary index rather than a popular benchmark such as the Barclays Capital US Aggregate Bond Index.

In November the financial giant announced plans to launch seven actively managed equity sector ETFs to be called iShares Evolved. Instead of tracking industry indexes created by financial companies and joint ventures like MSCI, S&P Dow Jones Indices and others, the funds will use indexes created by robots employing machine learning to classify potential components. The company did not comment further on its plans.

"Companies are trying to move the needle in terms of index creation," said Sullivan. "With self-indexing, a team creates a methodology to produce an index and then launches an ETF to track it."

Wisdom Tree Investments, one of the pioneers of smart beta investing strategies, is putting an active twist on passive investing in emerging markets. The company's WisdomTree China ex-State-Owned Enterprises Fund (CXSE) tracks a proprietary index of the broad market that excludes companies with more than a 20 percent state-ownership interest

"There seems to be a growing interest in actively managed equity products in an ETF wrapper." -Ryan Sullivan, vice president of global ETF services at Brown Brothers Harriman

"We focus the fund on companies that are freer to compete in the global market," said Luciano Siracusano, chief investment strategist for WisdomTree. "We're giving investors the option to control for the risk of state ownership." Last year the CXSE had a return of 80 percent — more than double the return on the iShares China Large Cap fund, which includes the state-owned enterprises in the index. WisdomTree has launched a similar fund, with ticker symbol XSOE, for the broader Asian market.

Last June the company also launched its first multifactor U.S. equity fund (USMF). It screens for 200 stocks with the highest combined score on four factors: value, fundamental quality, momentum and low volatility. "Factors behave differently in different markets," said Siracusano. "The goal is to get most of the upside [of the S&P 500] and protect against the downside."

In a suddenly volatile market, more investors may be looking for that kind of protection.

— By Andrew Osterland, special to CNBC.com

Financial Advisors

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