As active fund managers increasingly launch exchange-traded funds, Mark Latham looks at the way ahead for a vehicle that until now has been a byword for low-cost investment.
With smart beta funds expected to reach $1 trillion (€0.84 trillion) by the end of the year, 2017 has seen a rush of active fund managers launching smart beta or factor-based exchange-traded funds (ETFs) into an increasingly crowded marketplace. So, with firms competing aggressively on pricing, how can firms that have built their reputation on stock-picking compete with the established mainstream ETF providers, other than offering something substantially different and substantially better?
One fund house that has increased its presence in the ETF space recently is JP Morgan Asset Management, which launched its first European-listed ETFs into the €616 billion European ETF industry in November. Other predominantly active fund managers to do likewise this year include Fidelity International and Franklin Templeton.
JP Morgan AM is calling its two European ETFs, which do not track an index like low-cost mainstream ETFs, a hybrid of active and passive. These aim to provide returns similar to hedge fund strategies by using advanced, factor-based investing techniques Bryon Lake, head of international ETFs at JP Morgan AM, believes that continued innovation by active managers and tailoring products to suit specific investor needs is the best way to fend off competition from low-cost, purely passive managers. Providing investors with additional tools to ensure accurate portfolio construction will also, he says, help to propel the industry forward.
Asked at what point an index-tracking fund stops being merely a low-cost alternative to active management, Lake replies that ETFs should not be viewed as synonymous with index-tracking funds. He sees the ETF as a “wrapper”; what you put inside is the investment engine.
“The analogy with music is helpful here,” he says. “Your favourite song is your favourite song regardless of whether you listen to it on vinyl, a tape cassette, a CD or stream the song. The content remains the same while the delivery format can differ. But the overall investment decision should not be driven solely by cost. Investors need to ensure they’re paying a reasonable price for what they’re trying to achieve.”
Demand for risk-oriented smart beta (where stocks are screened for volatility impact on a portfolio) is now outstripping demand for return-focused smart beta. This was particularly apparent between 2015 and 2016 when risk-oriented smart assets grew 48%, compared with 22% for the return-focused variety.
Lake’s colleague Yazann Romahi, chief investment officer for quantitative beta strategies at JP Morgan AM, points out that, while the growth in smart beta strategies has largely used factor exposures to enhance return, there is now increased attention on the risk dimension of investing in equity markets.
According to Romahi, an intuitive interpretation of diversification – whereby the more stocks you hold, the more diversified you are – suggests that all index funds must be well diversified.
But in reality, traditional market capitalisation weighted indices are exposed to more concentration across sector, factor and stock-specific lines than a passive investor might think.
“Better diversification can significantly improve your risk-adjusted return and, since it is easy to implement in a simple, rules-based process, it is a natural next step in the evolution of smart beta investing,” he says.
According to Howie Li, the chief executive of Canvas at ETF Securities, it is important to recognise that not all smart beta (or factor-based) strategies are designed in the same way, as there is an expectation that the smart beta approach should reflect an asset manager’s internal capabilities.
“As long as the methodology is transparent and rules-based, then it will still be index-tracking,” Li says.
“There will be some approaches which are not as systematic and may incorporate discretion for managers to actively tweak but from an investor’s perspective, the due diligence will be around how consistent and repeatable any outperformance this discretion provides. This will tie into how a strategy/index should be priced and that is often assessed based on the value that the outperformance or risk enhancement delivers over a standard market-cap weighted index.”
Li, whose service creates ETFs for asset managers, points out that more investors are focusing on risk contribution and return rather than just outright performance. Managing a multi-asset portfolio, he has observed that investors consider whether the risk they take by making an investment is justified by the potential reward.
“This is demonstrated by increasing awareness of drawdown characteristics as well as the historical risk-return profile or Sharpe ratio,” he says.
Though equities have been performing well in recent months (and most smart beta products are in equities), Li says the focus on risk-oriented rather than return-focused smart beta products may reflect investor sentiment on how they need to position their portfolio in the near term more defensively.
Over at Sarasin & Partners, head of quant Andrea Nardon believes the trend towards active managers launching smart beta ETFs is set to continue. But he says in five to ten years, investment products will cease to be strictly classed as either active or passive. “Instead I believe there will be a form of index-tracking products, which will be tracking market cap indices like passive, but also indices that are built on a different logic – what we call today smart beta,” he says.
“In my opinion, active will take a slightly different shape, becoming more ‘activist’, where asset managers are expected to engage with company boards and take more of an active role in the corporate governance of the company they invest in and for sure, this will attract a lot of interest.”
Nardon expects ‘active’ based ETFs to continue to proliferate alongside ETFs that track market cap indices, and that prices will carry on falling. “The fact that fees have been going down is a result of a large amount of products in the markets and the more commoditised this market becomes, the more we can expect fee compression to continue.
“However, the focus for asset managers is and will remain to come up with investment solutions designed to achieve investors’ goals. I don’t see index-tracking being an alternative to active management,” he says.
“Index-tracking created liquidity for investors and enabled even the smallest investors to access the returns of asset classes difficult to replicate on a small scale. I think index-tracking will continue to be seen as a form of building blocks for asset allocators and in this respect, the larger the availability the better.”
Nardon believes demand for risk-oriented products is cyclical as investors can explain their advantages, particularly during rough periods. He says: “Right now, with equities trading at an all-time high, it is not unreasonable to switch out of market cap indices, which are highly exposed to yesterday’s winners, and move into low-volatility products.”
Alexander Davey, director and senior product specialist for alternative beta strategies at HSBC Global Asset Management, says his firm has experienced a gradual increase in passive and systematic (quantitative smart beta) strategies in recent years but that this has not been at the expense of HSBC’s active business.
“What in effect is happening is that new money is coming from lots of different pockets into lots of different areas,” he says. “There are undoubtedly some very strong traditional stock-pickers out there and they will continue to garner money, whereas 20 years ago they would have garnered all the money.”
Davey point out that less expensive vehicles typically congregate around something that is the index or something that is similar to the index and is delivered inexpensively. “So you have to be much more careful with that allocation cost,” he says.
“We do not see it as one wins and everybody else loses. We as a business have seen a really strong growth in our index and systematic strategies but we also continue to see assets growing in our active fundamental business.
“The aim for us is to push each part of that equity business forward, not one at the expense of the other.
“For me, it is about delivering the strategies in the format that is most effective for clients. The DNA of those strategies will be same, but you are going to get some nuances depending on the client and the mandate.”
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