There are plenty of blogs and white papers online with better definitions of “what is a smart beta ETF” and “what is an actively managed ETF”. We will post some links with some of the better articles in a separate post.

As the passive index ETF market reaches saturation of offerings, if not maturity in total assets, the next wave of growth appears clearly to be in ETFs that involve active professional investment management. There is a good economic reason why this not only can happen, it SHOULD happen. Consider, for a moment, how markets work. The principle of supply and demand drives prices. If the entire market is driven increasingly by uniform waves of demand from investors putting new assets into index ETFs, all stocks in the index fund being purchased have equal demand. Certainly no rational observer would suggest that all stocks in the index are equally attractive (or equally unattractive during periods of net redemptions).

So the question is, how can the markets combine the attractiveness and efficiency of exposure to broad sectors of the markets and global economy, while involving the analytics of comparing financial data and future prospects of the securities represented within the index?

A smart beta ETF will take, for example, the S&P 100 or some other common index, and select from the 100 companies a more limited number for investment. This number may be as low as 20 (needed for diversification under the Investment Company Act of 1940, under most conditions but not all) to as many less than 100 as the prospectus investment policies and limitations outline. A smart beta ETF will typically only adjust the securities into which it invests quarterly, or in some unusual circumstances, monthly. There are tax reasons for not making overly frequent adjustments, which we will address in another blog post soon.

An actively managed ETF might be less constrained by guiding principles of following an index and making infrequent adjustments. In theory an actively managed ETF could change its portfolio composition as often as the investment advisor or subadvisor deemed appropriate. There are significant reasons why an overly active ETF is not desirable. A key reason is tax treatment of ETF portfolio rebalancing. Another major reason is marketability of the ETF. The investing public seems to like the predictability and transparency of a known portfolio into which they are investing. Market makers in the ETF need to have systems in place to price the portfolio, and hedge the portfolio. This can be difficult if not impossible mechanically with an overly active ETF.

If we had a crystal ball our prediction would be that smart beta ETFs and actively managed ETFs will gain increasing market share over the next 10 years, but like most any market paradigm shift, it will not occur overnight and smart beta ETFs seem poised to be the next area of growth.