Computers are taking over the money-management industry.
At least, that's one conclusion to be drawn from the soaring popularity of so-called smart-beta exchange-traded funds, which employ algorithms that engineer stock portfolios based on "factors" like value, growth, low volatility, or some combination of them all. Big traditional money-managers like BlackRock (BLK) - Get Report , JPMorgan Chase (JPM) - Get Report and Goldman Sachs (GS) - Get Report are flooding the market with new ETFs to meet investor demand.
The number of smart-beta ETFs has doubled in the past five years to 579, while their assets under management have tripled to $471.2 billion, according to Morningstar. Last week, New York-based BlackRock, the world's largest money manager, projected that smart-beta ETFs' assets will surge to $1 trillion by 2020 and $2.4 trillion by 2025.
They're known as smart-beta funds because they purportedly improve upon the low-fee, purely index-based investing that's fueled the surge in total ETFs to more than $3 trillion; such passive strategies are known as "beta" because they aim to match the performance of an entire market, such as the Standard & Poor's 500, contrasted with "alpha" strategies that aim to beat the market.
Smart-beta ETFs are shaking up money management because they offer alpha at beta-like fees -- partly by using computer programs to replace human stock-pickers. The average fee for the new funds is 0.5% of assets, compared with 1.1% for active mutual-fund managers, according to Morningstar. The ETFs are also stealing market share from hedge fund managers who typically charge 2% plus 20% of any gains.
"It's the trend in the buzz-o-sphere," said Matt Hougan, chief executive officer of ETF.com, which tracks the industry. "It's all anyone wants to talk about these days."
Just last week, JPMorgan Asset Management started its eighth smart-beta ETF, the Diversified Return U.S. Mid Cap Equity ETF (JPME) - Get Report . The new fund filters U.S. stocks to identify medium-size companies with cheap market valuations, trading momentum and high-quality earnings, according to a statement.
It's "built to address the flaws of traditional indexing through a risk-managed, multi-factor process," according to the New York-based firm.
Just the fact that JPMorgan, which oversees at least $263 billion in mutual funds, would roll out a low-cost ETF shows traditional money managers' fear of becoming obsolete -- or at the very least the desire to hedge their bets.
Large institutional investors like pension funds are shifting money into the ETFs partly because they've soured on years of subpar returns from hedge funds and actively managed mutual funds, said Deborah Fuhr, a former BlackRock executive who now runs ETFGI, a research and consultancy firm in London.
In 2013, BlackRock, which oversees $4.7 trillion in total, rolled out three "factor ETFs" at the behest of investors including the Arizona State Retirement System, according to a statement at the time. One of them, the iShares MSCI USA Momentum Factor ETF (MTUM) - Get Report , already has $1.3 billion of assets.
"The clients are asking for it," Fuhr said. "Most of the big active houses struggle even themselves to have funds that are consistently beating benchmarks. If you're doing smart beta, at least you have consistency in how you apply the factors."
In June 2015, BlackRock hired Andrew Ang, former chair of Colombia Business School's Finance and Economics Division, to lead its factor-based strategies group, saying in a statement at the time that investors "will need to use data and technology" to outperform in constantly evolving markets.
According to Morningstar, BlackRock runs the two biggest smart-beta funds, the $29 billion iShares Russell 1000 Growth Fund (IWF) - Get Report and the $27 billion iShares Russell 1000 Value Fund (IWD) - Get Report . In third place is Vanguard's $20.6 billion Dividend Appreciation Fund (VIG) - Get Report .
Fidelity Investments, the $2 trillion mutual-fund giant, is on the verge of succumbing to the trend after filing for regulatory permission to offer smart-beta ETFs, InvestmentNewsreported last month. A Fidelity spokesman didn't respond to a request for comment.
One driver for the money managers is that ETFs can accumulate assets rapidly -- providing scale that can make up for lower fees. Goldman Sachs, for example, rolled out its ActiveBeta U.S. Large Cap Equity ETF (GSLC) - Get Report in September with a net fee of just 0.9% -- on par with the tariff for State Street's $181 billion plain-vanilla ETF tracking the S&P 500. The Goldman ETF has already amassed $637 million -- translating to roughly $6 million in annual fees for a fund that can be managed with a skeleton staff.
"Fund-company providers want to be in the space because they see that assets are going into ETFs," said Alex Bryan, Morningstar's director of passive-strategies research for North America. "There's been an explosion in demand."
Smart-beta funds now represent about 21% of total ETF assets, up from 16% at the end of 2006, according to Morningstar.
Invesco (IVZ) - Get Report , an Atlanta-based firm with $784 billion under management, published a document this year tracing the roots of the "revolution" to the investor ethos that emerged from the financial crisis of 2008. To wit, clients burned by record-high volatility and extreme uncertainty are now seeking the assured liquidity that comes from continuous trading on an exchange, and the accompanying transparency in pricing.
In just five years, BlackRock's iShares MSCI USA Minimum Volatility ETF (USMV) - Get Report , which seeks to smooth out the U.S. stock market's peaks and valleys, has gathered $11.9 billion, based on figures at the end of March. In around the same period, Invesco's PowerShares S&P 500 Low Volatility Portfolio (SPLV) - Get Report has gathered around $6.8 billion. Combined, the two ETFs' assets roughly equal the $19 billion boasted by 22-year-old hedge fund Paulson & Co., which made billions betting against the U.S. mortgage market during the financial crisis.
New York-based WisdomTree Funds, a specialist in smart-beta funds, has accumulated about $45 billion of assets under management in the past decade alone.
Of course, there's the risk of a bubble, where so many smart-beta funds chase the same stocks that returns diminish. Value stocks, for example, could quickly become overvalued; dividend-paying stocks could see shrinking yields; momentum stocks could quickly lose their momentum.
"As these anomalies are discovered, they may no longer exist," said Neena Mishra, ETF research director for Zacks Investment Research in Chicago. "What the investors may not realize is that by trying to outperform the market, they're basically taking a higher risk."
And while many of the new ETF strategies purport to be based on research demonstrating outperformance over the long term, they still struggle to beat broader market indexes, just like traditional active managers, said Morningstar's Bryan. In fact, he said, Morningstar prefers the term "strategic beta" to "smart beta" because the latter carries too positive a connotation. Other terms for the category include "alternative beta," "alternative indexing" and "advanced beta."
Fund companies "will want to tell you that" smart-beta ETFs outperform, just as traditional stock-pickers have claimed for decades, said Irene Bauer, another former BlackRock executive who's now chief investment officer at Twenty20 Investments, which assembles portfolios of ETFs for wealth managers.
Smart-beta ETFs "can work at times," Bauer said. "In the end, you're seeing the commoditization of what hedge funds did 10 years ago."