They might not be able to agree on a name for it, but smart beta – or factor investing, enhanced beta, or strategic beta, to give you a few examples of alternative names that are on offer out there – is mighty popular with investors.
Data from ETF data consultants, ETFGI, shows that, globally, assets invested in Smart Beta equity ETFs/ETPs have increased 21.9 per cent in the first nine months of the year to reach a new record of USD644 billion at the end of September.
The strategy bridges active and passive management in that it is designed to work as a hybrid alternative, achieving returns above the index. Smart beta ETFs takes a traditionally passive strategy and modifies it to achieve greater return by introducing different factors.
It is dominated by US equities. The ETFGI figures show that 88.7 per cent of smart beta assets are invested in the 628 ETFs/ETPs that are domiciled and listed in the United States and 76.8 per cent of the assets are invested in the 511 ETFs/ETPs that provide smart beta exposure to the US market.
iShares dominates the sector, gathering the largest smart beta ETF/ETP net inflows in September with USD2.63 billion, followed by Vanguard with USD1.06 billion and PowerShares with USD390 million net inflows.
Products tracking MSCI smart beta indices gathered the largest net ETF/ETP inflows in September with USD1.65 billion, followed by CRSP with USD1.05 billion and S&P Dow Jones with USD1.01 billion net inflows.
And the US equity smart beta ETFs have achieved outstanding performance. ETFGI data shows that if you combine market moves and net inflows, smart beta equity ETF/ETP assets have increased by 21.9 per cent from USD528.76 billion to USD644.40 billion, with a 5-year CAGR of 31.3 per cent.
And it’s not just happening in the US. According to data from Amundi, European investors’ enthusiasm for sectorial and smart beta ETFs, evident since the start of the year, was also reaffirmed in October. These categories of ETFs benefited from EUR2.4 billion of net inflows over the month, adding up to EUR19.2 billion since January, the firm says.
The vast bulk of smart beta ETF assets is devoted to smoothing out risk in a portfolio of equities by including factors. MSCI, creator of the smart beta factor indices writes that equity factor investing aims to capture exposures to different equity risk premia.
Factor modelling and factor investing are rooted in the Capital Asset Pricing Model (CAPM) dating from the mid-1960s, Arbitrage Pricing Theory from the 1970s and Fama and French’s three-factor model from the 1990s, MSCI writes.
In general, the term `factor’ refers to any characteristic of a group of securities that is important in explaining their risk and returns. While many factors have been shown to have statistical significance in explaining variations in risk and returns, not all of these factors offer premia relative to CAPM pricing.
Factor premia represent exposure to systematic sources of risk that have historically earned a long-term premium and MSCI has identified six factors that meet this criterion: Value, Low Size, Low Volatility, High Dividend Yield, Quality and Momentum.
These factors underpin much of what is going on in the rules-based product development within the smart beta sector. However, there is innovation beyond even this, with smart beta ETFs arriving on the scene designed to profit from other factors such as political change, religious beliefs, gender equality or entrepreneurship.
These ETFs are equally using factors to enhance returns through protecting from downside risk, smoothing out volatility and focusing on specific investment aims.
For some observers, smart beta is stepping into the active management space, offering a cheaper, more liquid approach to the returns that used to be the sole provision of hedge funds or other actively managed funds.
There are concerns about the rigour with which some smart beta products are created. Observers ask whether backtesting has been thoroughly done and whether performance data is clean data, arrived at through a rules-based process, or just data that has been tested until the correct result has been achieved.
But there can be no argument about the appealingly low cost of these hybrid vehicles. Smart beta ETFs come in at a higher cost than a vanilla ETF based on a household name equity index, but a considerably lower cost than the traditional 2 per cent management and 20 per cent performance fee based hedge fund model, while often achieving a very similar return.
Morningstar writes that as smart beta ETFs become increasingly popular, they become increasingly commoditised, profit margins are squeezed and fees fall. New entrants into the market expect and need volumes of sales to achieve their financial rewards, with fees as low as 0.22 per cent giving investors access to active investment in an intra-day traded vehicle.
More complex and multi-factor smart beta models may charge more but the average smart beta fee still sits at under 0.40 per cent as the competition for investors hots up in line with the appetite for the strategy.
And where to next for this popular asset class? Donavan Brown from BBH predicts an increase in demand for smart beta ETFs based on fixed income. Equities have dominated so far, but fixed income may yet have its day in the smart beta limelight.
Within the fixed income arena, the Barclays Aggregate Bond Index has dominated but the unbundling of a market cap weighted index can reveal smaller bonds that might offer exponentially bigger returns.
Within this special report, BMO details how it is offering income ETFs using fixed income in its various forms.
Other developments are likely to be within the thematic spot. Beyond gender neutrality and religious views, robotics and automation have had another good year as the sector offers diversification from the norm and a chance to hitch onto a sector which truly reflects the future. And finally, of course, the ETF based on cryptocurrency or blockchain has yet to formally make it to the table, but it can only be a matter of time as firms find ways to work around the existing legislation to create a product that investors increasingly demand.
