How Investors Are Using Smart Beta ETFs

May 24, 2017

USAA: Big Smart-Beta ETF User
As an example, out of USAA’s $5 billion in ETF assets today, $1.6 billion is in smart-beta ETFs specifically—the firm is one of the largest holders of the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC), for instance. That number is growing as a function of cost, liquidity and availability of these ETFs. (USAA’s global multi-asset team manages about $12 billion in assets spread across a mix of single stocks and passive and factor-based ETFs and strategies.)

At USAA, as at many other institutions, ETF usage exists for three main reasons: tactical allocation, cash equitization and risk management.

The majority of USAA’s global asset allocation portfolios are tactically managed across asset classes, sectors, regions and countries—it might be duration or credit exposure within fixed income, or different styles.

“Say we want to overweight high-yield bonds. It’s a lot more difficult to move money from one active manager to a high-yield portfolio manager in a timely fashion,” said Lance Humphrey, portfolio manager for USAA’s global multi-assets. “There could be an incremental cost, and it takes time doing that, so oftentimes it’s easier to use an ETF to gain that type of exposure.”

At the moment, USAA is finding fundamentally weighted strategies in the value segment attractive—funds like the Schwab Fundamental US Large Co. Index ETF (FNDX), the PowerShares FTSE RAFI US 1000 Portfolio (PRF), the Schwab Fundamental International Large Co. Index ETF (FNDF) and the PowerShares FTSE RAFI Developed Markets ex-US Portfolio (PXF).

“While we believe in holding long-term allocations to core factor portfolios—we believe in value, momentum, quality, size and low volatility—there are times where certain factors may be temporarily dislocated in our view. In these few instances, we may take a more tactical approach to our factor holdings,” Humphrey explained.

Managing Portfolio Risk
As a mutual fund manager, USAA sees cash flows go in and out of their portfolio every day, making cash equitization another big role ETFs play for the firm as a way to keep portfolios fully invested at all times. And then there’s the issue of managing portfolio risk.

“ETFs—particularly smart-beta ETFs—allow us to control risk and target certain exposures like factors that we may not be getting exposed to from our underlying active managers,” added Humphrey. “We tend to be very fundamental investors.”

That brings us to the alpha-seekers, the active managers BlackRock’s Fink said are driving ETF usage growth. We’ve all seen the headlines touting active managers’ failure to deliver outperformance after fees, and their struggle to do it consistently.

One of the big appeals of smart-beta ETFs is that they are, in a way, a quasi-active approach, offering deviations from pure market beta—in the pursuit of alpha—all for a fraction of an active manager’s cost.

Active Manager ETF Usage Expanding
“Use of smart-beta ETFs by active managers is starting to expand rapidly,” said Robert Nestor, head of U.S. iShares smart beta at BlackRock. “All portfolios are exposed to factors, and active managers broadly are becoming more aware of factors through the lens of risk models.”

So, how are these active managers using smart-beta ETFs? According to Nestor, in various ways. As a “complement to bottom-up stock selection strategies, to even out factor risk and to avoid factor exposure overwhelming stock selection,” he said.

Also, to “complement economic cycle calls, since they correlate highly with business cycles” among top-down managers using single-factor ETFs; and, finally, to “complement low-correlation hedge fund and alternative strategies” among risk allocators using low-vol strategies.

Some of the most popular iShares ETFs with active mutual fund managers, according to FactSet data, include the iShares Russell 1000 Value ETF (IWD), the iShares Edge MSCI Min Vol USA ETF (USMV), the iShares Russell 2000 Value ETF (IWN) and the iShares Edge MSCI Min Vol Emerging Markets ETF (EEMV).

In a world that’s increasingly indexed, and where fee compression only gets tighter, it’s perhaps unsurprising to see more and more active managers turning to these ETFs to lower their overall costs and manage risks, all while seeking alpha.

At the end of the day, as BlackRock’s Fink put it, an active manager can’t charge more than their excess return. It’s all about serving the client well.

 

 

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