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Magazine Issues » March 2014

ETFS: Proceed with caution

KeySmart beta is growing in popularity but some are sounding a note of caution, finds Nick Fitzpatrick. Transparency is needed more than ever, and it is important to understand how these products fit into market cycles.

He is a Cass Business School MBA, a former satellite engineer for the European Space Agency, and an industry peer describes him as one of the brightest quantitative analysts he knows.

But even so, Eric Shirbini is having trouble understanding some smart beta products on the market.

“I look at some of the rule books and still cannot figure how they work,” says Shirbini, who is now global product specialist at ERI Scientific Beta, a venture affiliated with the Edhec Business School, a French academic institution.

It is not a question of maths or big words for Shirbini, whose financial career spans 20 years; rather it’s a question of transparency.

Smart beta indices, which are used increasingly by exchange-traded funds (ETFs), weight stocks based on alternatives to the traditional cap-weighted scheme, such as by fundamentals, volatility, size, value or momentum. The idea is that “tilting” towards these factors will tap into a risk premium and produce a higher return than a cap-weighted index at certain times.

Investors who enjoyed returns from the smart beta ETFs that performed best over the past year – namely value and momentum – might not be worried about this fad-sounding sector, but caution is being signalled about the smart beta trend in the fast-moving ETF world.

Most recently, Towers Watson, an investment consultant, said it was “somewhat concerned about the proliferation of products now on the market that claim to be smart beta, particularly in the equity area”. This was after Towers saw clients more than triple their assets to $11 billion (€8 billion) in smart beta strategies across 180 portfolios in 2013.

And in recent months, Intech, a mathematics-led investment manager with $40 billion under management, put out three white papers about smart beta that ask if smart beta is just “old wine in new bottles”, and say that smart beta is neither passive nor smart as the popular smart betas have drawbacks.

Neither Shirbini, Towers Watson or Intech are writing off the latest ETF trend. ERI Scientific Beta which Shirbini works for is a smart beta index provider. But as the money flows, the message to investors is: scrutinise more; think harder.

“We’ve looked at quite a few smart beta products and they are only transparent to a certain level,” Shirbini says. “It can be hard to see what universes they are using, what their constituents are as they change over time, and how they calculate index weights.”

In 2012, the European Securities and Markets Authority issued guidelines for ETFs, saying that Ucits funds that invest in indices must “ensure that investors are provided with the full calculation methodology of financial indices”.

John Brown, head of global client development at Intech Investment Management, has questioned the integrity of indices in the popular low-volatility/minimum variance area.

These portfolios target the “low volatility anomaly”, where the received wisdom that higher volatility stocks produce higher returns is turned on its head by research showing lower volatility stocks can also boost returns. Some more sophisticated approaches may also consider correlations.

“To claim index status,” he wrote in paper called When smart is not that smart, many such approaches artificially constrain portfolio turnover, thereby limiting the potential for volatility reduction. Those which do employ optimization typically use proprietary techniques and risk estimates. As such, transparency into the portfolio is limited and it is questionable whether such approaches can truly be considered indices.”

Index investment is by extension passive. But Brown says one of the most “promulgated fallacies” about smart beta indices is that they are passive. “Without active trading, the efficacy (and impact) of these indices is diminished,” he says.

Picking on the momentum factor, Brown says this form of smart beta, which is dependent on identifying and systematically harvesting a targeted fundamental factor, can only be achieved by active trading.

He notes that momentum indices have seen “dramatic performance” over the longer term, but that dramatic underperformance in the short term as markets correct is not uncommon.

Momentum – the general idea being that good performance will continue – has been one of the better performing strategies in recent months, says Mary Allen Saunders, product specialist at UBS Global Asset Management’s structured beta and indexing business.

Saunders acknowledges the high turnover and says momentum is a factor that is hard to call right – entry and exit points can dramatically influence returns.

If the caution being broadcast about smart beta does cause investors to scrutinise more, Saunders highlights the need to understand risk premia.

“The core thing to remember is that you need to understand which equity factor risk premium is driving the performance of each smart beta and then make a decision about whether you think this will persist.”

Momentum is a pro-cyclical strategy, forming one of the five cyclical factors – the others being value, volatility, size, and quality.

Value, momentum and size are pro-cyclical; volatility and quality are defensive.

“It is necessary to understand which business cycle they are linked to,” Saunders says, adding that value outperformed last year while low volatility and quality underperformed. This year momentum has performed very well.

Of these cyclical indices, John Davies of S&P highlights quality as an area of interest this year.

“We are looking at quality weightings, which consider things like return on equity, cash flow, and other factors.

The interest appears to reflect an awareness of the market cycle.

“It follows the success of dividend indices. There has been a long-standing interest in good dividend payers and clients tell us quality is where they would like to go next.”

Both Davies and Saunders argue that blending smart beta is the way many intelligent investors will move forward.

This form of diversification recognises that risk premia factors will not always outperform cap-weighted benchmarks.

Product launches in Europe’s ETF market have been prolific in recent years. ETFs are feted for their transparency. The opaqueness of some smart beta ETFs could be a sign of an industry outpacing itself – or perhaps in order to deliver something special, the products have to give up something special, too.

Either way, the move towards smart beta registered by Towers Watson is real.

At a Funds Europe ETF roundtable in November 2013, it was found that even UK pension schemes, who are apparently resistant to the ETF product, might succumb to the lure of smart beta.

Neil Morgan, a senior pension trustee at Capita Asset Services, said: “For the vast majority of UK pension schemes, exposure to passive investment is through institutional pooled index funds provided by the key passive managers. There’s really no great appetite at all in the UK institutional space for ETFs – though it may be different for smart beta ETFs.”

©2014 funds europe