ETF spectrum: Aligning active options
ETFs are no longer just index trackers: today’s market spans traditional passive, systematic active, fundamental active and option-overlay strategies – so investors must look past the label.
Investing used to be simple. There were two clear choices: passive with low-cost index funds that tracked the market, or active with a fund manager who tried to beat it. Investors could either be a part of the crowd or bet on professional skill.
Systematic investing – with all its sophistication and machinery – muddied the waters. Tracing its roots back to Benjamin Graham and David Dodd in the 1930s, such strategies use hard metrics like price-to-earnings ratios in an effort to find mispriced stocks.
Fast forward through some major academic breakthroughs (Modern Portfolio Theory in 1952, Capital Asset Pricing Model in the 1960s), and suddenly the mathematical and computing power existed to industrialize and automate the approach. However, systematic strategies remained largely an academic curiosity and institutional privilege.
The wrapper revolution
The wrapper revolution
As systematic investing became more widespread in the 2000s and the blurring of active and passive really took hold, active exchange-traded funds (ETFs) threw another spanner in the works. The first actively managed ETF was launched in 2008 and heralded a new era: ETFs were no longer just about tracking indexes and benchmarks; they became flexible containers capable of holding any strategy.
This completely changed how we think about ETFs and prompted a wave of new language surrounding ETFs. Below is how we label the various ETF categories that have emerged
- Traditional passive ETFs – i.e., index trackers
- Systematic active ETFs – maintaining an element of discretion, these automate active factors like value or momentum, or can add active overlays to beta returns
- Fundamental active ETFs – where investment decisions are initiated and driven by humans.
Fundamental active is typically higher conviction – i.e., deviation from the benchmark is to be expected, and thematic views are often expressed through the overall portfolio exposures. Conversely, systematic active tends to have lower tracking error and risk budgeting.
There is another category emerging, represented by defined outcome or efficiency management ETFs. These involve option overlays where there is discretion and flexibility on the strike price obtained, as well as duration and liquidity management products such as short-duration fixed income.
Why this matters
Why this matters
With such a huge wave of innovation sweeping through the market, new products are being launched at a rapid rate. The language used to name and describe them is inevitably evolving, too. There’s an old Alan Greenspan quote about how being too clear meant people must have misunderstood him1.
That kind of vagueness might work for central bankers, but it is unwisefor investment managers. We are legally required to be crystal clear about what we are doing with our clients’ money.
For the modern investor, the lesson is clear: one must also look beyond the label. You can’t just buy “an ETF” anymore. You must understand the specific strategy and the risks it aims to take or manage. In a world of expanding investment options and evolving terminology, it is more important than ever to be upfront about what products do. Our classifications above are an attempt to do just that. Please feel free to contact us if you require more information.
