Interest grows in ETFs which promise to outsmart the market

It was only 15 years ago that the first exchange traded funds (ETFs) were appeared in Europe. On 11 April 2000, the LDRs DJ STOXX 50 and the LDRs DJ Euro STOXX 50 were listed on the Deutsche Borse, followed by an iShares ETF on the London Stock Exchange later in the month.

By the end of Q1 2015 the European ETF/ETP industry had assets of $492bn (€455bn) in 2,105 products, with 6,414 listings on 26 exchanges, according to ETFGI. And this remarkable growth shows no sign of slowing, with European ETFs seeing $34.97bn of inflows in Q1, well up on the $11.17bn gathered in the same period last year.

As the European ETF industry has grown, it has also evolved considerably, expanding from cap-weighted products tracking equity indices into far more complicated offerings, and although much of this is being driven by the product providers, they also have a willing audience.

“Investors want to see more innovation and surprisingly want to see more new products,” says Felix Goltz, head of applied research at the EDHEC-Risk Institute, which recently unveiled its survey of the European ETF landscape. He explains that although the ETF industry has moved into new asset classes as it has grown, innovation is tending to be seen in existing asset classes.

One of the hotbeds of innovation in recent years has been in the area of so-called ‘smart beta’ strategies, which are not cap-weighted and aim to generate superior risk-adjusted returns. According to business news broadcaster CNBC, around 7 per cent of ETF assets are now linked to these strategies. Of the respondents to the EDHEC survey, which included wealth managers, 25 per cent were already using smart beta strategies, while a further 40 per cent were considering using them in the near future. 

“There is usually conservatism in the industry so we were surprised by the appetite for smart beta,” says Mr Goltz. “The motivation for investing in this area is the belief that it may add value and outperform cap-weighted indices. Investors do want there to be full transparency and to know what the methodology looks like, though. This makes sense, after all transparency is a key benefit of ETFs.” 

One of the other great attractions of ETFs has always been their low cost when compared to actively managed strategies, but those opting for a smart beta product can expect to pay more. “There is more intellectual property and thought that goes into these strategies, so they are slightly more expensive than low cost ETFs, but are not high fee in any shape or form,” claims Hector McNeil, co-CEO of WisdomTree Europe, referring to the six smart beta ETFs the US firm launched into the European market in October last year, its first on this side of the Atlantic. 

“We don’t want to be fighting in that core low-cost beta market, we want to be in the more value-added unique space where we feel we can bring something different to clients.”

In addition to the six already launched, WisdomTree, which has $55bn in assets globally, plans another eight ETFs this year, and hope to have 25 to 30 products on the market in 18 months time. The firm is listing products in London, Switzerland, Germany and Milan and believes there is huge potential for smart beta strategies. 

“Since day one, WisdomTree hasn’t been a big proponent of market cap, although we do acknowledge there will be times when those strategies will perform,” says Mr McNeil. “Smart beta is exciting for the passive industry because it gives a much greater claim to providing the type of returns that are seen in the active world along with all the benefits that come with the ETF world, such as lower fees, market access and the ability to trade on exchanges.” 

He sees retail investors as a particularly fruitful area of growth, explaining how financial advisers are not just looking for straight beta but investment themes and ideas which can add value and they can take to clients.

However, there are some asset classes where ETFs in general, and smart beta in particular, face more of a struggle, admits Mr McNeil. “Fixed income is still a challenge for ETFs, because I think market cap doesn’t work as well as it does in the equity world. So even at the basic level fixed income is tough. I think smart beta is definitely going to be the way forward for fixed income, but I think it is easier said than done.”

But others see great opportunity in the fixed income space. Investors are having to contend with a low yield environment without much liquidity, and are forced into following buy and hold strategies when it comes to bonds, believes Stéphane Monier, CIO Europe at Swiss private bank Lombard Odier. This does not suit a traditional market-cap approach, he claims. “It doesn’t make sense to focus on the most indebted issuers, which is what the market cap approach does. You should be looking for those people who have a high capability of repaying this debt.”

While the smart beta discussion is quite advanced on the equity side, this is not the case with fixed income, claims Mr Monier. “We have been working with our institutional arm, Lombard Odier Investment Managers, in partnership with ETF Securities, to provide clients with transparent and cost efficient access to fundamentally-weighted fixed income ETFs which make for very useful building blocks in portfolios.” 

Investors are using ETFs to access a range of asset classes and are increasingly using them as a vehicle for long-term holdings as they can be used both strategically in their allocation as well as on a tactical basis, says Howie Li, co-head of the Canvas platform at ETF Securities. He expects smart beta strategies to continue to borrow investment techniques adopted by active managers. “As various techniques become more mainstream or new ones emerge as the industry evolves, there’s a good chance that these will be applied in the smart beta world provided they can be extracted and transparently applied in a systematic manner.”

Innovation in the industry is being driven both by investors searching for different tools to provide diversification within their portfolios, and the providers who continue to introduce new products, says Mr Li. “All of these developments benefit the investor as they enjoy greater choice and there are more products focused on providing return at a lower price.”

It is hard to ignore the rise of smart beta strategies, admits Daniel Pytlik, fund selection analyst at Bank Julius Baer. And he does see room for it as a little add-on which people try to experiment with, especially those with a speculative aspect to the way they look at their investments. But he warns that the performance they are able to deliver might not be anything like what they are promising.

“There will be times when market cap-weighted indices look terrible in performance terms compared to alternatives,” says Mr Pytlik. “We are going through such a period now which is why you are seeing so many of these smart products launched.” 

Quite a few smart beta strategies will have shown positive performance since the turn of the millennium, which is often the period of time they display the track record to investors, he claims. “But if you go back further, you can see this pattern is by no means to be taken for granted. Some of the most successful strategies in the smart beta space would have gone through a period of multi-year underperformance relative to market cap weighted indices in the run-up to the year 2000.”

One feature of these products is transfer of fiduciary responsibility from provider to client, says Mr Pytlik, as they react differently to certain market environments, so the investor has to take responsibility for the timing aspect. “Whereas individual investors might be able to do that, it is likely to attract a much more institutional type of client.”

It is not the case that smart beta strategies will replace traditional passive ETFs, or, at a wider level, that passive investments will mean the death of active managers, says Lorne Baring, founder of multi-family office B-Capital. It is about finding the most efficient vehicle for a particular investment.

The Geneva-based firm uses ETFs for the majority of its portfolios. “ETFs make up the core and we use active managers for the satellite,” he says. “We use the ETF vehicle where we see a lack of efficiency or need for an active manager. Within the ETF allocations we use a combination of smart beta and cap weighted strategies.”

B-Capital’s allocation to smart beta is more likely to come from the existing ETFs rather than at the expense of the active managers, says Mr Baring. “So we might have, for example, some US ETFs covering the US equity market, and we think we would like an income theme, so we might look at our S&P500 ETF and potentially take some of that and put it into a higher dividend, higher income ETF mapping the same index.”   

What's in a name

The debate about what role, if any, smart beta strategies should play in investors’ portfolios continues to gather pace, but one thing most figures in the industry seem to agree on is a dislike of the term itself.

“The name smart beta could almost be termed offensive to anybody who knows what is going on,” says Daniel Pytlik, fund selection analyst at Bank Julius Baer. “There is no reason why it should be considered smart. Beta is a much overused term – a technical term that makes sense within the framework of a particular theory about how the market functions but which hasn’t proved itself particularly useful in navigating the recent market’s ups and downs.”

Lorne Baring at B-Capital might use the products, but he avoids the phrase, preferring to use ‘factor investing’ when describing these strategies. “Smart beta might be catchy and easy to say but I always think that smart makes it seem as if it is going to do something clever and ETFs are not designed to do anything clever. They are designed to be passive.”

Even Hector McNeill at WisdomTree, which describes itself as “a smart beta innovator” and “pioneer” in the field, isn’t a fan. “We think the term smart beta is clumsy because it implies that market cap is dumb, which it clearly isn’t. We prefer the term passive alpha. It says what it does on the tin.”