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Inside Smart Beta: professional managers advance ETF boundaries

By: Rolf Agather, CFA, Managing Director of  Research

At the Inside Smart Beta conference I attended in September, it was impossible not to leave without being impressed by the continued evolution of the ETF space and in particular the influx of talent that is raising the level of industry conversation. It really hit home in my own panel - A Macro View: Factor Strategies for the Next Five Years – in which ETF strategist firms discussed the construction of modern ETF portfolios. The main takeaways: while index-based ETFs have attracted significant assets representing $2.4 trillion in the US alone[1], asset managers and advisors are taking advantage of the growing range of indexes and ETFs based on them, particularly in the factor arena, to build much more sophisticated portfolios than was possible even just a few years ago.

Consistent with this development, the information and knowledge gap between professional investors and those who go it alone without the help of a financial professional, is widening. We clearly have entered an era where professional money managers are able to build complex portfolios with ETFs, and the ongoing management of these complex portfolios requires tools and research capabilities beyond the typical non-professional investors. This didn’t happen overnight.

In the early 2000s, the ETFs that were popular were largely broad, cap-weighted index-based products, such as ETFs based on the Russell 1000, 2000 and 3000 Indexes. Offering investors a low cost, transparent and liquid investment vehicle, these ETFs were used by a marketplace of DIY investors seeking exposure to broad global markets. Emerging swiftly after that was the next generation of index-based ETFs which today might retroactively be considered the first smart beta ETFs, at least by some definitions. For example, Growth and Value ETFs introduced the technique of ratcheting up or down a given exposure based on the investor’s investment thesis.

The subsequent wave of smart beta ETFs came in earnest with the introduction of investable solutions that were designed to give investors the ability to fine tune portfolios by over or underweighting based on specific factors, like the ETFs based on the popular Low Volatility or Fundamental indexes. As noted in the chart below, these ETFs, defined as Enhanced Strategy ETPs by research firm XTF, have grown rapidly over the last several years. As is often the case, large institutions introduced the next breakthrough when they began combining factors as recently as 3-4 years ago.

 

So today we have a new generation of ETF strategists and allocators who are building portfolios around core ETFs - often based on broad indexes - and then using research and analysis tools to determine how to add exposures to achieve different investment outcomes. For example, many investors are concerned about the prospects of another Global Financial Crisis - similar to the one triggered in 2008 which saw markets fall by as much as 50% - and there are a number of low-volatility products that are designed to either reduce the ongoing volatility of the portfolio or to dampen some of the drawdown when extreme negative market events occur.

In other cases, investors are seeking to enhance income in what is now a low-yield environment. With bond yields at historic lows, some investors are turning to equity strategies that they believe provide access to higher yielding companies, and potentially with higher quality balance sheets to avoid some of the traps that can be associated with higher yielding stocks.

For those investors seeking alpha, many are looking to a number of single- and multi-factor investable strategies, as evidence by the feedback to our Smart Beta: 2016 Global Survey Findings from Asset Owners revealed. To the extent that the behavior of factors is cyclical, many investment products are now combining multiple factors to gain diversification.

The advancement of ETF investing over the past several years ultimately underscores an often overlooked feature of these now ubiquitous investment vehicles: flexibility. The traditional ETFs and investment models that fueled the explosive growth of the category remain a tool for non-professionals building buy and hold portfolios. Yet, at the same time, investors seeking a customized portfolio with additional sophistication now have a wealth of firms who can help them invest like large institutions.

 

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[1] MarketWatch, “Investors Piled into ETFs during Q3,” 10-6-16

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