How Investors Are Using Smart Beta ETFs

May 24, 2017

[This article appears in our June 2017 issue of ETF Report.]

There are some who say a lack of a clear, universal definition of smart beta is preventing adoption of these ETF strategies from going viral. Yet smart-beta ETFs are growing in number and assets. Why? Because everyone’s using them.

By our estimates and definition, smart-beta ETFs already represent about 45% of all U.S.-listed ETFs, and command roughly a third of all ETF assets. Driving that growth is no longer just the retail crowd, it’s all types of investors, particularly active managers.

In a recent interview with Bloomberg, BlackRock CEO Larry Fink assessed the ETF footprint in its entirety, saying, “One thing you have to understand related to the growth of ETFs is that a large component of the growth is not people seeking beta; it’s active managers navigating beta for alpha.”

Mutual & Hedge Funds Use ETFs
More than 1,200 open-end mutual funds today use ETFs, which, on average, account for about 22% of the value of the total assets in these funds. More than 370 U.S.-based hedge fund managers are investing in ETFs, based on their most recent filings, amounting to about 15% of the value of the total equity asset, according to FactSet data.

These numbers show that ETF adoption among active managers is strong, and on the rise.

The key to understanding how investors are using smart-beta ETFs is understanding why they’re using them.

Among ETF strategists, smart-beta ETFs are used to help advisors and their clients meet investment goals. That can take many shapes. At New York-based Ladenburg Thalmann Asset Management, which has some $2.2 billion in assets under management, smart-beta ETFs are primarily used for managing risk.

“You can gain access to risky asset classes in a risk-averse manner with smart-beta ETFs,” said Phil Blancato, CEO of the firm. “Strategic beta is still beta, not alpha.”

Toe-Dipping With Emerging Markets
The firm first tried its hand at smart beta in the emerging market space, looking for a lower-volatility portfolio in a pocket of the equity universe known for being riskier than most. Today Ladenburg Thalmann’s allocation to smart-beta ETFs extends into international, emerging market and fixed-income segments—that allocation includes funds like the J.P. Morgan Diversified Return International Equity ETF (JPIN) and the J.P. Morgan Diversified Return Emerging Markets Equity ETF (JPEM).

In the core of portfolios, however, Blancato said he still isn’t sure smart beta is the best fit relative to the traditional market-cap-weighted funds. Smart-beta ETFs represent only about 10% of Ladenburg Thalmann’s assets today.

“In the U.S. large-cap space, for example, I’m not convinced that smart beta is necessary yet. I don’t want to pay the extra fee there, because I think large-cap is efficient. Each asset class is different,” Blancato said.

The ETF wrapper has allowed unprecedented precision in exposure, and smart beta, specifically, has both broadened the reach and narrowed the focus of these exposures. As such, they’ve allowed portfolio managers to express various market views or make specific bets in ways they couldn’t before.

 

Most Popular ETFs With Mutual Fund Managers

For a larger view, please click on the image above.

 

Marrying Smart Beta With Macro
At Sage Advisors, an ETF strategist with $12 billion in assets under management, smart-beta ETFs come into play when they can easily be “married” to the firm’s macro views, according to Rob Williams, managing director at the firm.

“If we’re bullish on the dollar, and want currency-hedged overseas exposure, that’s the kind of smart-beta ETF we would look for,” Williams said. “We like smart-beta funds that have a very clear purpose, and that we can figure out when we should have it on and when we should take it off. We view them almost as a style bet.”

To that end, at Sage, smart beta only makes sense in its simplest form. We’re talking simple factor funds, or strategies like dividend-weighted, currency-hedged and low-vol ETFs. To quote Williams, “We stay away from ETFs that are very complex, have a lot of factors and a lot of moving parts.”

Multifactor Simplification
By contrast, for Blancato—whose firm he characterizes as a “hybrid” of tactical and strategic approaches—multifactor ETFs are great because they tackle the limited access of single-factor funds, and the concentration risk in certain stocks, sectors or countries inherent to single-factor strategies.

To him, using a smart-beta ETF is about not having to worry about “all the gyrations” of the market, and to be protected in case a given asset class underperforms in a market correction.

In both cases, the key to using smart-beta ETFs well in a more tactical way, Blancato says, is to look at them as market-environment-driven holdings, and not so much as a long-term allocation: Time horizon matters. 

In the institutional space, where time horizons tend to be longer, smart-beta ETFs are also finding a home, but it all comes down to finding the most efficient vehicle for a given target investment.

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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