He adds that the move to launch smart-beta and active products makes sense for Fidelity (see Figures 2 and 3): “Our heritage is active; it’s the quantitative research we’ve been doing since 1965 that feeds into our mutual funds.”
That same research gets codified into an index that Fidelity uses for smart beta. Bobby Barnes, quantitative analyst at Fidelity who works on the firm’s factor ETF products, says Fidelity’s general approach to passive is to minimize what he calls the “unintended risks” when creating factor products, which he says separates Fidelity from the crowded field of smart-beta offerings.
Barnes says stocks that score high on certain factors can be concentrated in a particular sector versus the broader market. Additionally, size can have a bigger impact than expected. “Factor products have a much smaller weighted average market cap than, say the S&P 500,” he said, meaning that ETF holders may be inadvertently making a midcap or small-cap bet in addition to the factor they’ve selected.
Finally, Barnes says the team considers security-specific risks, making sure they equally weight across attractive names. In factor ETFs, the index shouldn’t have a very large weight in a particular stock. “Once you’re in the top 10% or 20% of attractiveness on each factor, each of those stocks has similar odds of outperforming. You’re better served if you spread out that weight equally,” he said.
Another way Fidelity separates its smart-beta offerings from other issuers is its proprietary models it uses for value, quality and momentum. “We’re very transparent on what goes into them, such as what we use to define momentum,” Barnes noted. “We put it on our website. These factors we use come from our internal models we’ve used for decades to make investment decisions. We just offer these same insights into passive products.”
Clients Looking For More
Friedman says he believes clients are looking for excess return now, which smart-beta and active ETFs can offer. Another trend Fidelity can ride is client interest in models. “ETFs are phenomenal building blocks for models,” he said, noting investors are less interest in buying single stocks.
“People aren’t saying ‘I need to buy a particular ticker.’” Friedman added. “They’re saying, ‘How do I get yield? How do I get lower volatility?’”
Flows are strong this year, he says, noting the first six U.S. equity factor ETFs have more than $1 billion in total, and flows are going into both the smart-beta/active ETFs and the passive sector funds. Their fixed-income active ETFs are also seeing more flows lately, with Friedman noting the Fidelity Total Bond ETF (FBND) has AUM above $540 million.
Although Fidelity uses the same in-house research for ETFs it uses for mutual funds, he’s not worried one vehicle may become more popular than the other.
“Each client is different; clients don’t want the same product,” Friedman said. “It’s never a mutual fund versus an ETF story. It’s never an ‘are we worried about cannibalization?’ story. Our story’s always been what vehicles our clients want, what solutions we can provide them and making sure we bring them choice, value and innovation as we do that.”