Morningstar Magazine - June/July 2018 - 91

Many index mutual funds have been wrapped into
the target-date funds that are the default
investment option in many defined-contribution
plans or are otherwise featured in 401(k)
plans' investment menus. Investors' default setting
in a 401(k) plan is, generally speaking, inactivity.
I'm not surprised that we've seen relatively
better behavior, on average, among investors in
index funds.
Would those same findings apply to the major market
cap-weighted ETFs?

have seen median annual turnover in excess
of 100% that have not distributed taxable capital
gains across that stretch of time.
There are certain advantages, but the math
of active management remains the math of active
management. Some of these funds will be
successful by virtue of skill or just dumb luck, and
others will fall short. The distribution of outcomes
among this new form of active management
is similar to what we've seen with traditional

flesh-and-blood active managers: The majority fall
short. The single most reliable way to get
an idea as to how they'll perform in the future
is to look at their fee.
Martijn, have you done any work with active share
on ETFs?

Cremers: Only a little bit. The factor-investing
ETFs are a form of active management, but
their active shares tend to be lower because they
don't do that much security selection. They

Johnson: Absolutely not. The group of investors
that utilize exchange-traded funds and
the different use cases for exchange-traded funds
are far greater and more varied than for mutual
funds. SPY, the oldest exchange-traded fund in the
U.S. and the most heavily traded exchangelisted security on the planet, is used by individual
buy-and-hold investors, but also by Delta
One arbitrage desks.

Passive Akin to Active
Big market-cap-weighted ETFs have most of the assets,
but there are a large number of funds that are
lumped under the term strategic beta. Are these akin
to actively run mutual funds?

Johnson: What we call strategic beta, what others
have branded smart beta, are factor-based
strategies of all different forms that are manifest
in the indexes and the ETFs that track them.
These are for all intents and purposes just a new
form of active management, but strategic
beta tries to remove or reduce some of the
headwinds that traditional active management
faces-first and foremost, fees.

Almost uniformly, these strategies charge lower fees
relative to actively managed mutual fund peers
in their categories. They also remove an element of
idiosyncratic risk, specifically manager risk. When
you're outsourcing security selection and portfolio
construction to an index, you don't have the
risk that a key manager may up and leave, or that
the process will change or deteriorate.
Also, you see a lift with respect to tax efficiency
on the ETF chassis. There are strategic-beta
ETFs that over the course of the past five years

If you can't handle the manager underperforming his benchmark by 10%, don't hire
a manager with close to 10% tracking error.
Ben Inker

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Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018