Waldron: Fundamental ETFs A Misnomer
In recent weeks, Portfolio Solutions’ Rick Ferri kicked off a debate with Rob Arnott on whether it’s right to call certain ETF strategies “smart beta,” arguing that marketing campaigns are getting the best of ETF providers to the detriment of investors. Now, Dan Waldron, ETF strategist at First Trust, a firm that has its own lineup of fundamental ETFs, is adding another wrinkle to that battle of semantics, suggesting that what most call “fundamental ETFs” is anything but fundamental.
IU.com: We estimate there is about $175 billion today linked to fundamental ETFs, and about 21 percent of that asset growth came in the first half of 2013 alone. Why do you think fundamental ETFs are catching on?
Dan Waldron: Part of it is the active versus passive debate—that debate has been raging. I don’t know if it will ever be completely solved or agreed upon, but we think a majority of financial advisors still believe in active management. They’re disenfranchised with their mutual funds; they’re disappointed with the performance they’re getting from their favorite mutual funds. If you look at the ETF market’s $1.5 trillion size, the mutual fund market is about $8.5 trillion. When you take out money market funds, and funds of funds, the opportunity set is so much greater, and the fact of the matter is that more advisors believe in active management than passive.
It’s no surprise there are over a dozen and a half mutual fund companies that have filed to get into the ETF market, and some have already come in. They know what we know, that if you can deliver better risk-adjusted excess returns—also known as alpha—in an ETF wrapper, the ETF vehicle is just a better way of delivering active management.
IU.com: Is fundamental indexing passive investing or is it active investing?
Waldron: There have been a number of sponsors that have come out calling themselves fundamental, and we have a real issue with that because when you look at fundamental investing, you look at what professional stock pickers use, money managers use, they don’t use size, they don’t use market cap, which is the way most indexes are constructed.
They don’t use things like total earnings or total dividends, total book value. They look at quality factors, not quantity. They look at what the price is that they pay for that book, what price they pay for that dollar of sales, what kind of return on assets the company is generating, the kind of price momentum the stock is experiencing.
So, I think that a lot of these fundamental indexes are simply better beta or alternative beta. It’s just a way of owning the market and weighting them. It’s not fundamental. In a broad definition of what is fundamental, market cap is a fundamental figure for a company. But when it comes to fundamental investing, it’s not. You never hear a professional money manager say, “I bought this stock because it’s really, really, really big.” They say, “I bought it because the price I’m paying for this big company is reasonable” or: “The price for dollar of sales that they’re generating is reasonable.”
IU.com: You’re saying that the metrics some firms call “fundamentals” on which they base ETFs should actually be called something else?
Waldron: They should be called “better beta” or “alternative beta.” They’re really trying to compete with the traditional ETFs. They’re trying to say, “Hey, you can buy the S&P 500, it’s weighted based on market cap, but how about based on total book value or total earnings or maybe select stocks based on total dividends?”
But those are all highly correlated with market cap—the bigger the company, the larger the sales in general, the bigger the total dividends. These aren’t quality measures, they’re quantity measures; so I just want to call a spade a spade. A lot of these are basically just better beta or alternative beta, not fundamental.
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