Triple A of Hot ETF Themes: Alts, Active and AI

In person events are a great way to put your finger on the pulse of an industry, and to get a sense of the latest state of things. The Wealth Management EDGE/Inside ETFs conference, where more than 1,500 people – almost 60% of them financial advisors – got together last week in Florida delivered exactly that. 

For ETF enthusiasts, alternatives, active management, and artificial intelligence dominated conversations at the event. The “triple A” of ETF themes in 2023, if you will.

The Power of Alternatives

Finding uncorrelated return streams in challenging markets remains top of mind for advisors everywhere. Whether that means turning to physical and digital assets, derivatives-heavy and options-based strategies, long/short portfolios, and things like private equity, never have we heard the word “diversification” thrown around so much as the only way forward.

As an industry, we seem to be in a must-manage-risk-first mandate even as markets deliver relatively strong results this year. The call of the day is to diversify in the face of so much uncertainty, especially now that correlations between equities and bonds have made a traditional 60/40 portfolio riskier than before.

One thing is for sure, as one asset manager put it, “No one is getting paid to sit on cash.” Diversification is key, but so is participating in the market. Stay invested. And alternatives allow you to do that.

Interestingly, part of this diversification story is the growing adoption of actively managed ETFs. Think of it as implementing manager diversification in the pursuit of a little extra return where possible.

The Value-Add of Active ETFs

We’ve seen active ETFs dominate product innovation, representing more than 60% of ETF launches in the past year, and so far in 2023, they have attracted about 30% of new asset flows – that’s about 2x the pace of asset gathering the category saw in 2022.

“Active ETFs are one of the industry’s megatrends of growth,” one asset manager said. 

As we know, actively managed ETFs come in many flavors, with some offering barely more than closet indexing, some delivering rules-based active management, and some offering completely unconstrained strategies. Manager due diligence remains a big challenge for advisors – some told us the biggest hurdle to implementation is figuring out how to go about evaluating these active approaches.

One of the ways to begin tackling this task is by looking at active share, ChangeBridge’s Vince Lorusso offered – the metric that’s directly linked to the value-add of an active manager.  

At the ETF Think Tank, we can help with that due diligence. For example, one of our tools, “smart cost”, calculates the overlap between an ETF and a benchmark in an effort to understand what you are paying for (and getting) for the “smart” or alpha-seeking part of an ETF. See example below: 

Source: ETF Think Tank

Data is your friend in evaluating active managers, but it’s interesting to note that product proliferation – and success in asset gathering – isn’t necessarily tied to a portfolio manager who has become a household name and found a loyal following – think the Cathie Woods or Peter Lynch-es of the world.

Today, active management is just as much about a household brand where portfolio managers themselves aren’t immediately known, or they have an existing track record in the mutual fund space. In this case, it’s the firm’s investment philosophy and/or reputation that’s the selling point behind the value proposition of active management. Think firms like J.P. Morgan, Dimensional, T. Rowe Price, Capital Group – they now run some of the biggest active ETFs in the market.

The Lessons of AI 

Tangentially related to active management is the rise of artificial intelligence in the ETF industry. AI has been one of the hottest themes in the market this year, but in the ETF space, it’s a two-pronged conversation.

On one side, AI could change the way ETFs are built. To that extent, AI is “old news” having long been a tool in the smart beta and fundamental investing space. As Bloomberg’s Eric Balchunas put it, “I don’t see AI taking over everything. It’s going to be a lane within smart beta.”

And as a lane, it so far has had a mixed history of success. Consider AIEQ, a pioneer in this space as an ETF that relies entirely on IBM Watson (AI) to select stocks from a universe of “1,000 research analysts, traders and quants working around the clock.” (See fund details here)

Since inception, AIEQ has lagged the S&P 500 significantly and consistently. Why? Because turnover is massive on this strategy – turnover equals trading costs.

“Someone needs to teach the computer to do nothing,” Balchunas said. “If IBM Watson learned from its mistakes, it would stop trading so much. AI needs to meet Vanguard halfway.”

Still, as a portfolio construction tool, AI could lead to fee compression in the active space if it turns out AI solutions end up replacing or disrupting the value proposition of an active manager. The threat of “there’s an AI for that” should at least keep active managers on their toes, and fees in check. AI could also, as one industry participant put it, ultimately “democratize alpha.”

The other side of AI in ETFs is as an investment theme – a flavor of the burgeoning segment of thematic ETFs. Here, it’s still early days with few pureplay companies to pick from, but plenty of product innovation and thematic funds emerging in this space. “Right now, the supply side of AI funds is way ahead of demand,” a portfolio manager noted.

The hype around AI is real, but it may be a little ahead of itself for now.


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