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Beverly Chandler, GFM

Smart beta ETFs begin to impact on active funds


Smart beta data from ETF data provider ETFGI reveals that assets invested in smart beta ETFs and ETPs listed globally reached a new high of USD687 billion, following net inflows of USD9.15 billion and market moves during September.

Smart beta fills the investor’s need for targeted investment outcomes, as revealed by the contributors to this year’s Smart Beta Special Report from Global Fund Media.

Other research from Moody’s published in its latest report on ETFs and passive funds predicts that in Europe, ETF growth will propel European passive funds towards 25 per cent market share by 2025.

The Moody’s report describes the ETF as a viable tactical tool for implementing short- to medium-term views.

“Investors can use sector and geography focused ETFs for directional thematic trades, both long and short. With the increasing size and granularity of the ETF market, institutional investors including hedge funds are also increasingly using ETFs to assume risks previously taken via futures and OTC derivative products. Unlike futures or swaps, which may require additional operational hurdles and portfolio management expertise, ETFs enable portfolio managers to easily adjust their portfolio exposures so as to mitigate major risk factors, including equity, credit and interest rate risks. This allows them to quickly adjust their investment exposure.”

Moody’s notes that active asset managers are also increasingly using ETFs as part of traditional and multi-asset portfolios to build flexible, liquid, cost-efficient solutions.

The firm writes that there is growing demand for fixed income ETFs, as well as for thematic ETFs, such as those that take environmental, social and governance (ESG) issues into consideration. 

“While most of the flows go to plain vanilla ETFs, demand is also growing for ‘multi-factor’ or ‘smart beta’ ETFs. These funds follow an index, but rely on multiple factors – such as quality and value – and incorporate decision-making processes to actively adjust the level of exposure to different factors and betas. Multi-factor ETFs are more research intensive, and often compete directly with traditional mutual funds,” Moody’s writes.

This month has also seen new research from the Lyxor Dauphine Research Academy that reveals that the introduction of passive funds has helped investors by increasing competition in asset management. 

In 2018, the Research Academy focused on the relationship between passive and active management, specifically looking at what role the growing passive space has left for active managers. The research from Cao, Hsu, Xiao and Zhan found evidence that the introduction of passive funds has increased competition, revealing that the increasing availability of smart beta funds is forcing active managers to demonstrate that they can deliver true alpha in order to continue to gather flows.

Academic institution the EDHEC-Risk Institute announced the results of the 11th EDHEC European ETF and Smart Beta and Factor Investing Survey, recently as well. This study is conducted as part of the Amundi research chair at EDHEC-Risk Institute on ‘ETF, Indexing and Smart Beta Investment Strategies’. 

This survey, conducted since 2006, is designed to provide insights into European investors’ perceptions, practices and future plans in the domain of ETFs and Smart Beta. 

EDHEC-Risk writes that this year, the survey also included a special focus on Smart Beta product development, considering specific client demand in the fixed income field.

The survey reveals that since 2006, the increase of the percentage of respondents using ETFs in traditional asset classes has been spectacular: in 2006, 45 per cent of respondents used ETFs to invest in equities, compared with 92 per cent in 2018. 

About two-thirds of respondents (67 per cent) used ETFs to invest in Smart Beta in 2018, a considerable increase compared to 49 per cent in 2014 and respondents most frequently used Smart Beta/Factor-Based exposures to harvest long-term premia (as opposed to tactical use), the survey found.

Despite this strong motivation, more than 80 per cent of respondents invest less than 20 per cent of their total investments in Smart Beta and Factor investing strategies.

The survey found that 50 per cent of investors still plan to increase their use of ETFs in the future despite the already high maturity of this market and high current adoption rates. Top concerns for the respondents are the further developments of Ethical/SRI ETFs, emerging market equity and bond ETFs and Smart Beta ETFs, including multi-factor and smart bond indices.

EDHEC-Risk writes that respondents showed a significant interest for Fixed Income Smart Beta solutions and plan to increase their investment in it, but they do not consider there to be enough research in the area. The development of new products corresponding to these demands may lead to an even wider adoption of Smart Beta solutions, the Institute says.

Commenting on the study, Professor Lionel Martellini, Director of EDHEC-Risk Institute, said: “ETFs are increasingly regarded by institutional asset owners as key investment vehicles in the implementation of strategic asset and factor allocation decisions. The new frontier now is the development of meaningful smart factor investment solutions in the fixed income space. More academic research is needed in this area, which has become one of the main areas of focus for EDHEC-Risk Institute.”

More research published in this last quarter, came from Jason Hsu and John West from Research Affiliates and was provocatively entitled: ‘The Biggest Failure in Investment Management: How Smart Beta Can Make It Better or Worse’.

Here the pair posited that the negative gap between investor returns and fund returns is the biggest failure in investment management – with alpha only a sideshow.

They write in their paper: “If we extrapolate the investor returns gap to smart beta strategies, poor client timing will completely negate the potential for positive excess returns. The client service model for smart beta strategies needs to be radically different from other types of strategies to produce better investor outcomes.”

Their paper concludes that the gap between dollar-weighted and time-weighted returns – the investor returns gap – is a substantially larger figure, and therefore a greater cause of concern for investors, than underperformance versus a benchmark.

“The investor returns gap means that even for asset managers skilled enough to produce alpha, chances are their clients won’t be able to fully capture it in their own portfolios because of the clients’ investment timing decisions. For this reason, we call the investor returns gap the biggest failure in the investment industry.

“At the end of the day, for investment professionals to successfully deliver on their mission to clients, they must help them earn a positive dollar-weighted alpha over time. This means not only must investment professionals design strategies with robust sources of return and implement them in a cost-effective manner, they must also strive to help clients understand how to stay the course by understanding the styles in which they choose to invest.”

The Research Affiliates study found that many high-tracking-error smart beta strategies may actually exacerbate the investor returns gap, especially if noisy short-term performance is sold to trend-chasing clients. 

“The investor returns gap of nearly 2 per cent will wipe out the majority of smart beta strategies’ long-term returns. But we’re optimistic. We believe this cycle can be broken. Robust, academic-quality research and efficiently designed products are important, but no longer enough. To avoid the biggest failure in investment management, we must embrace a new conversation.” 

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