Has availability of liquid exchange-traded funds (ETF) designed to exploit predictive stock market factors (smart beta ETFs) affected the mutual fund industry? In their May 2017 paper entitled “How Do Smart Beta ETFs Affect the Asset Management Industry? Evidence from Mutual Fund Flows”, Jie Cao, Jason Hsu, Zhanbing Xiao and Xintong Zhan examine the impact of ETFs that do not track the market (smart beta ETFs) on mutual funds. They focus on U.S. equity and assess effects of smart beta ETFs by measuring mutual fund investment flow sensitivities to equity factor alphas over time. They quantify alphas using a 5-year rolling window of historical data. They split their sample into to subperiods, an early one with low smart beta ETF trading volumes and a late one with high volumes. Using monthly trading volumes, returns and assets (sizes) for 4,587 U.S. equity mutual funds and for 747 U.S. equity ETFs, and contemporaneous U.S. equity factor model returns, during January 2000 through December 2015, they find that:
- 227 sampled ETFs track the market, and 520 do not. For the former (latter):
- Average monthly return is 0.66% (0.47%).
- Average size is about $2.1 ($1.1) billion.
- Average trading volume is 42.8 (33.7) million shares.
- Risk factor exploitation is uneven among the 520 ETFs that do not track the market. Most target the size factor or an industry. Just 27 target value in third place. Very few target the momentum factor.
- Sensitivity of investment flows to factor model alphas increases significantly from the low to high subperiods of smart beta ETF trading volume. In other words:
- Investors are increasingly capturing factor returns via smart beta ETFs.
- Mutual fund managers must increasingly outperform multi-factor models of stock returns, not just the broad stock market.
- Based on two measures of sophistication (sentiment and mutual fund buying channel), this shift is stronger among sophisticated investors than retail investors.
- The shift is stronger for factors targeted by many (such as size) than few (such as momentum) smart beta ETFs.
In summary, evidence indicates that investors are turning to smart beta ETFs to capture equity factor premiums and requiring mutual funds to beat these betas.
Cautions regarding findings include:
- The sample period is not long for measuring investment industry trends (for example, in terms of independent 5-year measurement intervals for factor alphas).
- The data collection/processing methodology is complex and thus susceptible to model design snooping.
- The study does not address whether the shift from mutual funds to ETFs for capturing factor betas improves investment performance.
