Look Beyond the Wrapper: Why Selectivity Matters in a Crowded ETF Market

ETF inflows were approaching a record even before the fourth quarter began, and investors are heading into year-end with more choices than ever. Active, thematic and specialized strategies have multiplied, giving investors new tools but also making it harder to separate lasting strategies from passing trends. As the market grows more crowded, the wrapper itself matters less than what’s inside it.

Matt Barry, head of ETFs at Touchstone Investments, believes the industry’s rapid growth puts a greater premium on selectivity, with investors needing to focus on where strategies can play a meaningful, long-term role in their portfolios. He discusses why investment process and staying power matter in the active ETF boom, the risks of chasing the latest launch or theme, and why small caps and international markets are coming into focus as investors look beyond concentrated U.S. mega-caps.

CM: What do you see as the most significant change in the ETF industry today, and what does it mean for investors?

MB: The most significant change in recent years has been the continued evolution of ETFs from primarily passive building blocks into a vehicle for a much broader range of investment strategies. The SEC’s adoption of the ETF Rule (Rule 6c-11) in 2019 helped accelerate that shift by standardizing the regulatory framework for ETFs and making it easier for asset managers to bring actively managed strategies to market. Over 3,000 active ETFs have been launched since the ETF Rule was adopted, and investors now have access to active ETFs across a growing range of asset classes, investment styles and portfolio objectives.

That expansion offers investors more choices, but it also places more responsibility on investors and advisers to understand what they own. When ETFs were predominantly passive, evaluation often centered on the index, tracking error, cost and liquidity. With active ETFs, investors increasingly need to evaluate the investment manager, process, portfolio construction and risks just as they would with any actively managed strategy.

CM: How should advisers evaluate a newly launched ETF when the fund itself has a limited track record?

MB: A new ETF does not necessarily mean a new investment strategy. With the proliferation of active ETFs in recent years, many issuers are bringing strategies to the ETF market that have been offered through mutual funds or other vehicles for years. Advisers should look beyond the ETF’s inception date and determine whether the manager has experience implementing the same or a substantially similar investment process elsewhere. The track record of a comparable strategy can provide useful insight into how the investment process has performed across different market environments.

Advisers should also evaluate qualitative factors, including the experience and stability of the investment team, the repeatability of the investment process, how the strategy seeks to generate differentiated results, and the risks associated with the approach. Ultimately, a limited ETF track record should not be viewed in isolation. Investors should have sufficient evidence to understand what they are buying and why they believe the investment process can deliver over time.

CM: What should investors understand about the distinction between an ETF wrapper and the investment strategy inside it?

MB: An ETF is ultimately an investment vehicle, or wrapper, that can hold a wide variety of investment strategies. The wrapper itself is important because it can provide meaningful structural benefits, including intraday liquidity, trading flexibility, potentially lower costs and greater tax efficiency. But those benefits are distinct from the merits of the investment strategy inside the ETF, which will ultimately be a key driver of investment outcomes.

That distinction has become increasingly important as active ETFs have grown. Investors should first consider whether the underlying strategy makes sense for their portfolio and whether the manager has a differentiated and repeatable investment process. They should then evaluate how effectively the ETF wrapper delivers that strategy, including considerations such as expenses, liquidity, trading characteristics and tax efficiency.

CM: Why are small caps a particularly promising area for active managers, given factors like greater dispersion and lower analyst coverage?

MB: Small caps can provide a particularly attractive environment for active security selection because the opportunity set is broad and the differences between individual companies can be significant. Compared with large-cap stocks, smaller companies generally receive less sell-side research coverage and can exhibit greater dispersion in fundamentals, business quality and returns. That can create more opportunities for skilled managers to identify companies whose prospects may not be fully reflected in their valuations.

Those characteristics can become particularly important during periods of changing market leadership. Small-cap indexes include companies with widely varying balance sheets, earnings trajectories and sensitivity to economic conditions, which can create a wider gap between stronger and weaker businesses. For active managers with deep fundamental research capabilities, that dispersion can create greater opportunities to add value through security selection, while also making risk management particularly important.

CM: What are the most common mistakes investors make when selecting an ETF, particularly around popular market themes?

MB: One of the most common mistakes is starting with recent performance rather than the role an investment is intended to play in a portfolio. That risk exists across many types of strategies but can be particularly pronounced with thematic ETFs. By the time a strategy or theme has generated significant attention and strong recent returns, investors may have already missed a meaningful portion of the opportunity or may be investing at a less attractive entry point. Investors should instead understand the exposure an ETF provides, the risks that drive its returns, and how it complements their broader portfolio.

Another common mistake, particularly when evaluating newer ETFs, is equating secondary-market trading volume with the ETF’s overall liquidity. A newer or more thinly traded ETF may have relatively low average daily volume, but market makers can often provide additional liquidity based on the liquidity of the ETF’s underlying holdings and the creation and redemption mechanism. Investors who focus only on an ETF’s trading volume may therefore underestimate its available liquidity and overlook potentially compelling investment opportunities.

CM: What ETF trends do you expect to matter most in 2027?

MB: Active ETF growth should remain one of the industry’s most important trends in 2027. We expect asset managers to continue bringing established active capabilities into the ETF structure while also developing strategies specifically for the ETF market. Active ETFs should continue to deepen their presence beyond categories where they have already gained significant traction, such as fixed income and U.S. large-cap equities, into areas including options-based strategies and defined-outcome strategies, international equities and small caps. This continued expansion should give investors access to a broader range of investment approaches through the ETF vehicle.

Another development to watch will be the continued evolution of ETF share classes and mutual fund-to-ETF conversions. Both can bring established strategies with existing assets and track records into the ETF market, potentially addressing some of the challenges advisers face when evaluating newly launched products. ETF share classes remain in their early stages as issuers launch initial products and industry infrastructure continues to develop, while we expect mutual fund-to-ETF conversions to remain an important source of new ETF offerings in the near term. Over time, we expect the market to increasingly include a mix of de novo ETF launches, mutual fund conversions and ETF share classes.