SPONSORED FEATURE: Building on smart beta ETFs

Francois MilletFunds Europe talks to Francois Millet, head of ETF & Index product development at Lyxor Asset Management about developing new smart beta ETFs but maintaining solid fundamentals. Lyxor has launched a number of new smart beta ETFs this year. What was the thinking behind the new products?
This year we have launched eight new smart beta ETFs. Five of these are single factor ETFs that we have launched in partnership with JP Morgan. And the remaining three are diversified minimum variance ETFs based on FTSE indices. Traditional minimum variance products have been very popular strategies with pension fund managers since 2008 and have expanded very rapidly. They have been successful in reducing risk by about 20-30% and have also generated good returns. But the devil is in the detail.  The volatility reduction has been achieved at the expense of more concentration risk. So they have solved one problem but created another. This is why we have worked with FTSE on their suite of minimum variance indices that achieve  same risk reduction with a broader stock selection and a better distribution of weighting. Is the JP Morgan partnership something new for Lyxor?
Traditionally we worked for smart beta with proprietary strategies from our research and development headed by Thierry Roncalli, or with third party providers like FTSE. But the partnership with JP Morgan is a new source of product development. It is working with Lyxor because we share the same views on risk factor portfolio construction. There are five single factors that matter – momentum, low beta, quality, value and low size, they must be simple to understand and applied at regional level rather than globally. We are also preparing a new set of multi-factor ETFs to be launched from October. I refer to these products as smart beta 2.0. Previously we were seeing a lot of outcome-oriented smart beta ETFs but now the interest is in more bottom-up factor-based products aimed at capturing single risk factors and combining them through multi-factor solutions. Are you aiming the two different ETFs at two different types of investor?
Investing in a mono-factor smart beta ETF is more suitable for experienced investors who have better awareness of their risk factor exposure and seek to control it. For example, an insurance company looking for low volatility equities to lower solvency capital requirements. They are building blocks for re-composing a portfolio but they need to be handled with care. You need to understand what risk factors are missing in order to select the right ones. It is a strategy that is designed to combine different risk cycles to cater for different market conditions.  The multi-factor smart beta ETFs are designed for investors that are starting from a blank sheet and looking for an off-the-shelf product that has the diversification built in, for example a private bank or wealth manager. Is the smart beta ETF world transparent enough for today’s investment market?
The smart beta world is generally index-based and indices are transparent. They are produced by independent, index calculators via a published methodology. The smart beta ETFs are certainly more transparent than active funds and ETFs by definition – they are rules-based and those rules are well-known. However, I still believe that ETF providers have an obligation to explain how their products work to their investors – but that is a different issue to transparency. To that end, we do a lot of roadshows to help with the education of investors.  There are a lot of smart beta ETF products out there and some of them have become commoditised over time but there are still many that are new and becoming ever more exotic with an ever increasing number of risk factors involved. This is a phenomenon that economist John Cochrane referred to as a ‘zoo’ of factors. For example we  see theories on the January anomaly effect and an ETF based on the end-of-month effect. We believe that smart beta ETFs should respect three rules: they should be based on solid academic background, they should be empirically verified. Above all, you need to be able to explain theoretically how it works to your investors.  Are new smart beta ETFs in danger of being too complex for their investors?
This is always an issue for any new strategy and smart beta ETFs are still relatively new and are backed by some powerful marketing. There are safety nets for investors through regulation and Ucits rules but one thing investors should ensure is what constraints and what inputs are being used, for example what risk estimators. . The strategies may be very complex but simple enough that investors can calculate their risk exposure for themselves.  Do you expect the smart beta ETF market to continue growing?
I think we will see more mono and multi factor products being launched as well as some active smart beta ETFs. The lines will continue to blur between these type of ETFs and quantitative-driven funds. But I do not think the market has peaked. The flows to smart beta are still predominantly coming from active funds so there is still a lot of leeway for smart beta to grow further.  For example, the Boston Consulting Group recently said that passively managed funds account for only 10% of assets under management but that growth is much higher in this sector. At Lyxor we have already raised €6.5 billion in 2015 mostly in traditional ETFs. A lot of capital is moving from actively managed funds to ETFs. The benefit of smart beta is that it can deliver active management more systematically and cost-effectively. Many strategies work well in volatile conditions. Risk based and minimum volatility are good defensive strategies in times of high market volatility. While we can never be sure what will happen next in markets, I expect volatility to continue for a while longer and that can only be good for smart beta ETFs. ©2015 funds europe

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