Active managers big buyers of ETFs for 'smart indexing'
An unknown secret about passive funds is that they are increasingly being snapped up by active fund managers "navigating beta for alpha", says BlackRock CEO Larry Fink. Figures from Deutsche Bank show 59% of all ETF assets in 2016 were owned by institutional investors, a 17% increase on the previous year. Money manager Tom Dorsey dubs the approach "smart indexing" and claims "being passive, but being smarter about it, that’s the way of the future." Holding periods for some large ETFs are longer, however widely-traded ones like the SPDR S&P 500 ETF, which averages 15.4 days, tend to be shorter, says Morningstar.
Active managers are looking awfully passive lately.

While the debate between active and passive management has been raging for years, one seemingly contradictory aspect of it has occurring behind the scenes: portfolio managers are “getting active with passive,” as Ben Johnson, director of global ETF research at Morningstar, recently tweeted.

Active managers individually select the components of a portfolio, while passive management simply involves tracking an index. Not only are passive funds cheaper than their active counterparts, but data have repeatedly shown that they get better long-term results, with few managers able to consistently beat the market over long period. As a result, investors have been decisively moving toward passive products. According to Morningstar, active funds saw outflows of $285.2 billion in 2016; passive funds attracted inflows of $428.7 billion over the same period.

Increasingly, however, its active managers who are buying the passive products, using them as portfolio components to give their funds cheap and broad exposure to various asset classes and categories. The number of mutual funds that hold ETFs has more than doubled over the past decade, while their median size within the fund has risen by a factor of nearly four, accounting for 4.5% of the fund’s assets.

According to Deutsche Bank, institutional investors owned 59% of all ETF assets in 2016, up 17% from the previous year. Global ETF assets were $3.4 trillion at year-end 2016, according to research firm ETFGI. Investment advisors held $813 billion of total ETF assets at the end of last year.

Larry Fink, the chief executive officer of BlackRock BLK, -0.10% (one of the largest providers of ETFs), recently credited this trend to the overall explosion in ETF growth, which has taken ETF assets to $3.7 trillion globally, according to research firm ETFGI.

“They’re doing asset allocation,” Fink told Bloomberg. “It’s cheaper; it’s more efficient; you have less idiosyncratic risk than in any one stock. So I actually believe one of the unknown secrets about the growth of ETFs is that they’re heavily used by active managers.”

He added, “A large component of the growth is not people seeking beta; it’s active managers navigating beta for alpha.”

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Beta usually refers to an asset’s tendency to be volatile, while alpha represents returns above a benchmark.

Source: Morningstar

When active managers use ETFs, they use them in extremely active ways, data show. The largest and most widely traded ETF, the S&P 500-tracking SPDR S&P 500 ETF Trust SPY, +0.28% , tends to be held for the shortest period. According to Morningstar data, it is held for just 15.4 days, on average (including weekends). Another heavily traded index fund, the Nasdaq-100-tracking PowerShares QQQ Trust Series 1 ETF QQQ, +0.71% , is held for 22.3 days, while the SPDR Gold Trust GLD, -0.23% is held for 43.7 days (see chart above).

““Being passive, but being smarter about it—that’s the way of the future,”” — Tom Dorsey, founder Dorsey-Wright & Associates

The Morningstar data look at the 10 largest ETFs by assets, and of these, there were some held for more significant periods. The Vanguard Total Stock Market ETF VTI, +0.31% is held for an average of 354.2 days, nearly twice as long as the fund with the second-largest holding period, the iShares Core U.S. Aggregate Bond ETF AGG, -0.18% (187.4 days).

Comparatively, retail accounts hold U.S. equity funds for 20 months, according to S&P Global Market Intelligence.

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Tom Dorsey, the respected money manager who founded Dorsey-Wright & Associates, an investment advisory firm that builds portfolios through ETFs and index funds, referred to this strategy as “smart indexing.”

“You can do better than the market without leaving indexing, and the role of the advisor is to help clients wade through all the index choices out there and help them navigate them,” he told MarketWatch earlier this year. “Being passive, but being smarter about it—that’s the way of the future.”