INNOVATION: New directions

Reverse index ETFs, small-cap ETFs, high beta ETFs: providers of smart beta ETFs are nothing if not inventive. Fiona Rintoul examines the latest trends.

At just over ten years of age, smart beta is entering a new phase of maturity. While 2018 has so far not been the best of years for smart beta approaches in terms of net new inflows in Europe, the palette of smart beta ETFs on offer continues to expand to meet investors’ changing needs.

“There was some disappointment in some strategies last year,” says François Millet, head of ETF and index product development at Lyxor Asset Management. “We are in a phase of consolidation.”

Data from Lyxor AM’s ‘Smart Beta Money Monitor’ show modest net inflows of €606 million to smart beta ETFs in Europe in the first quarter of 2018. The second quarter saw net outflows, bringing year-to-date inflows close to zero in Europe. The biggest outflows in the first quarter were in minimum-volatility/minimum-variance strategies, which lost €318 million, though these saw moderate inflows of €90 million in the second quarter.

“Minimum volatility/minimum variance makes sense,” says Millet. “We are in a new period of volatility.”

Despite this display of modified rapture, there is a sense that smart beta ETFs and perhaps particularly factor investing are finding their place in European portfolios. “Broadly speaking, the case for factor investing is starting to be well understood by investors as a transparent and index-based way to outperform the benchmark,” says Vincent Denoiseux, head of portfolio solutions at DWS, who notes that most factor ETFs in Europe are single-factor.

DWS has developed a matrix that allows investors to combine factor plays with other dimensions such as regions.

“It’s a contradiction for some investors who say it’s not about regions,” says Denoiseux. “But most investors still look at regions and decide what would work best in each region.”

Multi-factor ETFs remain a fairly small part of the European smart beta ETF universe. Assets under management (AuM) are €4.1 billion out of a total smart beta ETF AuM of €34.5 billion.

However, this is a likely direction for the future.

In the US, DWS has launched multi-factor funds in collaboration with FTSE. In Europe, bi-factor funds have hit the market. In April this year, DWS launched two quality-focused high-dividend ETFs.

“There is some consolidation on two factors,” says Denoiseux. “As for any financial innovation, there are early adopters, conservative investors and sceptical minds. Our job is to address them all.”

Meanwhile in 2017, Research Affiliates, which is something of a pioneer in smart beta, introduced a suite of indices that facilitate multi-factor investing.

“We’re starting to see quite a bit of investor interest and some healthy flow pick-up,” says Vitali Kalesnik, head of equity research at Research Affiliates Global Advisors in Europe.

The company, which had total assets of $157 billion licensed to its indices at the end of May 2018, was at the forefront of smart beta when it introduced the Research Affiliates Fundamental Index (RAFI) in 2005. RAFI is a non-price-weighted index that uses fundamental measures of company size. Using these measures, it rebalances out of securities whose prices have increased, creating a systematic contrarian approach.

Most of the investors in both Research Affiliates’ new multi-factor indices and the RAFI Fundamental Index are institutional. Alongside smart beta ETFs and mutual funds, Research Affiliates offers segregated mandates. The latter obviously allow institutional investors to benefit from lower fees, which can boost overall performance.

“With smart beta funds, as with any investment, it is important to be aware of all the costs associated with the fund,” says Daniel Ung, smart beta ETF strategist at SPDR. “According to research conducted by S&P, the average cumulative impact of the fee differential between active funds and ETFs invested in European equities were more than 7% over five years.” The cost differential might be less among smart beta ETFs, but it still pays to shop around.

However, for Kalesnik, low fees are just one of the reasons to choose smart beta strategies. Equally compelling – especially for institutional investors such as pension funds – is the transparency smart beta strategies provide. “It’s fully transparent and understandable,” he says. “Many investors pay less attention to this fact, but it’s pretty important if you have boards of trustees.”

As everyone knows, ill-informed or confused investors tend to buy at the top of the market and sell at the bottom. Because of this, Kalesnik reckons, investors can lose as much as 200 basis points a year. “The degree of transparency in smart beta could reduce that turnover,” he says.

As smart beta ETFs evolve in Europe, it should become possible to pass these benefits on to non-institutional investors. Smart beta ETFs can provide solutions to specific investment issues and can be used in a range of different scenarios to reduce risk and potentially improve performance while keeping a lid on costs, Ung believes, making them suitable for a wide range of investors.

“Although institutional investors – such as pension funds and asset managers – were the first to adopt smart beta strategies, potentially they also have a part to play in a range of investors’ portfolios,” he says. “They can also help a range of investors to achieve diversification cheaply and flexibly both within and across asset classes.”

Although net new flows to smart beta ETFS have been muted so far this year – or perhaps because of this – the range of products on offer is growing all the time.

“The market needs a new impetus,” says Millet.

In the case of Lyxor AM, that impetus comes from the Lyxor Scientific Beta Developed Long/Short Ucits ETF. This provides exposure to the Scientific Beta Multi-Beta Multi-Strategy Managed Volatility L/S Equity Market Neutral Index from the Edhec Risk Institute (ERI), which aims to generate absolute performance with limited volatility and low correlation to the broad equity market. The long leg is exposed to the six factors of size, value, momentum, low volatility, profitability and investment, and the short leg is exposed to a broad market cap-weighted reference index. The strategy also aims to minimise beta.

“A traditional hedge fund strategy is not neutral in terms of beta,” says Millet. “Edhec’s focus is to minimise the beta as much as possible and take it close to zero.”

It’s a strategy for our times, he suggests. With financial markets teetering as result of rising global tensions, now is a good time to look for sources of return that aren’t correlated to equities and bonds. A fixed leverage of 3.5% is applied to the product.

“It’s very reliable,” says Millet. “We prefer to apply fixed leverage to a strategy that has beta close to zero.”

Another way to go beyond equities and bonds is through multi-asset ETFs. However, multi-asset ETFs – in common with long/short ETFs and multi-factor ETFs – do have the disadvantage that they remove simplicity.

“Investors need to be prepared for a little bit more complexity,” says Kalesnik, who also cautions that “factors are not a free lunch”. Momentum performs really well until it doesn’t and is prone to clusters. Value can be sluggish in normal times, and investors can endure five to seven years of underperformance.

“Investor education is important,” he says. “Investors need to understand exactly what they are getting and why.”

In the sphere of fixed-income smart beta, DWS, with its strong background in bonds, has been something of a pioneer. Products include quality-weighted fixed income ETFS and higher-yielding fixed income ETFs. DWS had also defined factor strategies in fixed income. “It’s a less crowded area, but factors are not just for equities,” says Denoiseux. “It’s always takes time when products are launched, but we’re now seeing flows.”

Financial repression
While investors have tried to tilt their portfolios to cope with the financial repression created by quantitative easing, dividend ETFs have also seen flows. “Smart beta ETFs make it possible to fine-tune a portfolio and with interest rates being so low over the last decade, many of our investors opted to supplement their core portfolios with an allocation in dividend ETFs with the aim of boosting their income,” says Ung.

For the future, prepare for more long/short ETFs. “We expect to see competitors launch them,” says Millet, who also hopes to see development of products with dynamic rather than static allocation to the factors.

It hasn’t been a great year for flows to smart beta ETFs, but practitioners are confident of future growth as this area of the business consolidates and the range of strategies increases. “The financial industry is very conservative,” says Kalesnik, “but I’m pretty sure that ten to 15 years down the road, a big part of investors’ portfolios will be invested in this type of strategy.”

©2018 funds europe



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