Smart beta strategies start to gain traction

Exchange traded funds enjoyed a record-breaking 2017. Globally, assets in ETFs and ETPs [exchange traded products] increased by $1.29tn over the course of the year, including inflows of $654bn, to reach $4.84tn, according to research firm ETFGI.

And there are no signs of this growth stopping anytime soon; indeed January was another record-breaking month, pushing assets through the $5tn barrier for the first time. “We project the global ETF market to more than double in assets under management by 2022,” says Jane Sloan, co-head of iShares Emea sales at BlackRock.

Three global trends should power this growth, she explains: the rise of fee-based wealth management, networked bond and derivatives trading, and alpha-seeking usage by active fund and wealth managers of ETFs.

The types of investors who are using ETFs has widened, explains Ms Sloan, while existing users are deploying ETFs in new ways. “Traditionally ETFs were primarily used by institutional investors, but they are increasingly a staple in retail investors’ portfolios, as they are seen as a cost-effective, liquid and fast way to achieve desired exposure to an asset class.”

January saw the 25th anniversary of the listing of the first ETF in the US, the SPDR S&P 500 ETF, and since then the landscape has been dominated by equity products. But there are signs this is starting to change. iShares reports fixed income ETFs  surpassed $750bn in 2017, with assets growing by 25 per cent a year over the past five years, while trading volume has more than doubled. It predicts bond ETFs to be a $1.5tn market by 2022.

Research by KPMG highlights how six in 10 UK retail investors are using ETFs to gain exposure to the bond market, and they are commonly using ETFs in areas of the bond markets where they believe it is more challenging to generate alpha, such as short duration and inflation-linked bonds.

Investors are demanding more innovative ways to weigh fixed income index products, says Ms Sloan. “Factor based investing has primarily been an equity phenomenon, but fixed income smart beta strategies have started to garner more interest from investors placing greater emphasis on identifying drivers of risk and return in order to meet specific outcomes.” 

She predicts factor based fixed income strategies will grow in popularity among investors, in turn leading to more products.

One reason for the slower take up of fixed income ETFs compared to equities may be the traditional thinking has been that investing in bond markets required an active approach, says Clemens Reuter, head of passive and ETF investment specialists at UBS Asset Management. “However, there is an increasing realisation that fixed income ETFs can help to deliver cost effective and transparent access across a wide spectrum of exposures in this area.”

There has also been a great deal of innovation in underlying fixed income indices tracked by ETFs which has added to their attraction, he explains. “Smart beta in fixed income is very much at the nascent stage, but an area which deserves attention. Growth here is a certainty.”

The sudden return of volatility to stockmarkets  in early February has led some commentators to suggest that investors may look to pull out of ETFs and seek out active managers instead in the belief that they would be better suited to weather any storm. But Mr Reuter does not believe that this would necessarily be the case. 

“ETFs cover an ever-increasing number of exposures across a wide range of asset classes,” he says. 

“If investors start to take a more cautious view on equities, then we would expect to see some shifts out of equity ETFs. However, a good portion of these outflows could easily move into fixed income ETFs. Interest in alternative beta ETFs has grown exponentially over the last couple of years and we expect that to continue as investors become more comfortable with them as a cheaper rules-based alternative to active management.”

UBS uses the term ‘alternative beta’ rather than ‘smart beta’, and Mr Clemens says these strategies now form an integral part of what it needs to be provided to its client base. The sector is already growing, and this will only increase as investors gain a greater understanding of these strategies, he believes, explaining how UBS is continuing to widen its product range in this area. 

Happy customers

Investors who try smart beta seem to like it, with 97 per cent of users reporting their allocations are meeting or exceeding expectations, according to research by Invesco Powershares. Three in four plan to increase their allocations, and 87 per cent would recommend these strategies to colleagues.

There is very much a preference towards equities rather than bonds for the entry point for new users of smart beta, reports Chris Mellor, equity product specialist at Invesco PowerShares Emea. 

The Invesco survey suggests one of the reasons investors are using smart beta is to improve diversification in portfolios (see chart). “You can do that in a number of ways, by diversifying across a number of funds or approaches, or picking funds with a particularly diversified portfolio within them,” says Mr Mellor. “If an investor is seeking, for example, income, then they probably don’t end up buying just one smart beta income product.” 

When combining multiple factors, investors need to be aware of how the strategies will impact on each other, he warns. “For example, putting together a value index product with a momentum index product wouldn’t give you true diversification as they are liable to cancel each other out.”

The starting point for smart beta strategies was in the “classic” dividend/income, value and growth type products, says Mr Mellor, but in recent months, areas such as momentum, quality, risk-weight and equal-weight products have seen significant inflows. 

Yet some investors remain unconvinced by smart beta. “It’s clear there is a degree of scepticism, particularly among non-users. Most of those are firm believers in active management.”

When deciding to allocate to a smart beta strategy, investors should be paying particular attention to costs, says Vitali Kalesnik, head of equity research at Research Affiliates. “Fees and transaction costs remain important,” he says. “If you are comparing two managers and one is twice as expensive, in all likelihood the cheaper manager will outperform the other.”

Firstly, investors should look at the management fees, he says, and ensure the strategy is efficiently designed when it comes to transaction costs, as these can be hidden away and may amount to more than the management fee. 

The fact that smart beta strategies are lower cost than active management should provide them with an “ongoing tailwind”, says Mr Kalesnik, supporting further growth.

Although there has been considerable fee pressure in plain vanilla market-cap weighted ETFs, a factor which has seen these strategies dominated by the big name providers, when it comes to smart beta it is all about adding value, claims Nizam Hamid, head of ETF strategy at WisdomTree Europe. “There is far less fee pressure if you can demonstrate you add outperformance.”

Winning over wealth

Wealth managers are becoming interested in ETFs, because their end clients have asked them about these products, he says. “Why don’t I have them in my portfolio, I have heard that they are low cost, transparent products so why don’t I have them? Why am I holding a high cost active fund?” 

There is a lot of pressure on wealth managers and private banks to incorporate ETFs, because their clients tend to be savvy investors, he says. 

“Wealth managers in the past might have been not too bothered about ETFs, but if the pressure is coming from your end client then it is hard to ignore.”

The wealth management industry is certainly a key target for ETF providers, and many private banks do indeed see these products as key building blocks in constructing portfolios.

“We use ETFs across our client portfolios and view them as part of our always-evolving multi-asset tool box,” says David Storm, head of multi-asset portfolio strategy at RBC Wealth Management. 

ETFs provide a cheap and efficient way to take market risk across a broad range of indices, but they do have limitations and may not always be the best way to implement this strategy, he warns. For example, in a late cycle market environment with central banks unwinding QE, greater dispersion across individual stocks and bonds can be expected, and a more active approach can help to generate outperformance. 

“We might use a government bond ETF as a nimble way to adjust interest rate exposure and use that alongside a truly active portfolio manager with a broader opportunity set to generate outperformance.”

RBC uses smart beta strategies, splitting them into three groups: return-oriented (value, growth, quality), risk-oriented (minimum volatility, risk parity) and other (equal-weighted, multi-asset).  Last year it ran an overweight to the ‘growth’ factor in its European equity allocation, explains Mr Storm, and having done well, it reduced that overweight moving into 2017 by adding exposure to a ‘value’ factor. 

“Combining factor and fundamental investing has become an increasingly important part of our investment process,” he adds. “It helps to improve our decisions and smart beta ETFs provide a way to manage risk and target specific solutions and outcomes for our clients.”

Investec tends to allocate more to active than passive strategies, says Adrian Todd, Fund Selection Specialist at Investec Wealth & Investments, but does use ETFs as low-cost ways to provide exposure to key regions and asset classes. “ETFs are sometimes used to reflect changes in asset allocation views quickly and efficiently," he says. "In some portfolios, ETFs are also used alongside high-conviction active managers in the same asset class and region in order to average down the TER and overall tracking error of that part of the portfolio. Most of our ETF exposure is centred around core equity regional exposure where there has been significant price completion such as large cap US and UK exposure.”

Smart beta products are not heavily utilised by the firm at present, though Mr Todd reports it is incorporating them into our assessment of our active managers. “For example, when assessing the performance of a large cap US equity manager, a more relevant assessment of whether the manager has done well could be a sensible income-focused smart beta ETF rather than the S&P 500 index.”

But not all wealth managers are won over by the virtues of smart beta, or indeed by ETFs in general.

“When it comes to ETFs, not much has changed within our discretionary portfolios,” says Sue-Wei Wong director, investment specialist managed investments at Citi Private Bank. 

“We have always been advocates of active management. If we are including ETFs, then it is very small allocation and almost to complement our more active managers. Or we have used them to implement tactical allocation decisions quickly. But it has never been for the core part of our portfolios.”

Although she reports clients have displayed an interest in discussing the benefits of ETFs, actual implementation has been extremely limited.

The rise in equity markets over the past few years, along with QE, has seen the correlations between asset classes increasing, but Ms Wong expects to see those correlations breaking down in this late bull run. 

“The fundamental part of active management will start playing through into client portfolios. Selectivity in markets will definitely become a lot more important. And that is resonating with our clients.”  

Regulatory reshuffle

An updated version of the Markets in Financial Instruments Directive, or MiFID II, came into effect in January, with the intention of strengthening protection for investors and improve transparency across European financial markets. 

The asset management industry is expected to be greatly affected, not least the ETF market. Around 70 per cent of ETFs are currently traded over-the-counter, rather than on exchanges, but MiFID II requires comprehensive, detailed reporting of ETF trades.

The ETF industry is very much of the opinion that the increased transparency will help spur future growth, as should some of the other rules that are coming into force.

“Greater transparency on costs puts the spotlight on value for money and in turn will drive increased adoption of ETFs and index funds alongside active and smart beta funds in portfolios,” says Jane Sloan, co-head of iShares Emea sales at BlackRock.

MiFID II will drive assets that would have normally gone into US ETFs into European-listed funds instead, believes Hector McNeil, co-founder and co-CEO of HANetf. 

“The American products might be bigger, with established track records, but the regulation is going to strangle the ability of brokers to offer those products to their clients,” he says. 

“It will become essential for US and Asian issuers to provide more information, the KIDs, the PRIPs, all those types of things which they won’t want to do and which cost money. I have heard estimates of up to half a trillion dollars that could potentially come back into European products.”

VIEW FROM MORNINGSTAR: Spoiled for choice

By the end of 2017, strategic beta exchange traded funds held approximately €44bn, or 9 per cent of the total assets in ETFs domiciled in Luxembourg or Ireland. Strategic beta, otherwise known as smart beta, funds aim to improve the risk and return profile of market-cap weighted indices by tilting towards one or more factors, such as value, momentum and size.

The strategic beta ETF offering is growing fast. Fifty-two of such products came to market in 2017 and six in January this year, bringing the total to 230. Most of the new launches were multi-factor ETFs. Academic research suggests individual factors tend to outperform the market over the long-term, but they can go through long spells of underperformance. By combining factors, multi-factor funds aim to smooth out the ride.  

Despite the in-roads made by multi-factor funds, the backdrop of rock-bottom interest rates ensures that income-oriented single-factor strategies continue to rank at or near the top of the list of the most popular strategic beta ETFs. Generally speaking, these strategies pick the highest dividend-paying companies from indices such as the S&P 500 or the FTSE 100. 

One problem with dividend-oriented passive funds – particularly the first products that came to the market – is that many of the benchmarks they track do not apply income sustainability filters. The iShares UK Dividend ETF – rated Negative by Morningstar analysts – belongs to this cohort. 

But index construction has evolved over the past few years and the newer strategies address this issue. In 2017, for example, nine strategic beta ETFs focusing on quality income were launched. The funds screen for high-dividend-paying companies and assess the health of their balance sheets, among other quality-related metrics. 

As the European ETF market continues to grow, one can only expect more innovation in strategic beta product development. This increases the available options, but also makes it more difficult to choose; not least because these investment propositions are becoming increasingly complex. Although rules-based, they are now often constructed using opaque algorithms, making them hard to analyse. This can be an unwelcome development for an ETF industry that prides itself on simplicity and transparency. 

Then there is the added issue that most strategic-beta funds do not have long live track records. As such, it will take many market cycles to assess whether they behave as expected.

All this serves to further underscore the importance of researching and seeking proper advice prior to committing one’s money into innovative investment solutions.  

Monika Dutt, Analyst, Passive Strategies, Manager Research, Morningstar