Smart Beta: Beyond The Hype

Smart Beta: Beyond The Hype

Despite all the buzz, advisors have reasons to be wary of such strategies.

Reviewed by: Debbie Carlson
Edited by: Debbie Carlson

[This article appears in our June 2019 issue of ETF Report.]

These ETF launches accounted for the bulk of 2018’s 230-plus new ETF products. Of the more than 2,200 U.S. ETFs available, smart beta accounts for anywhere from 30% to a little less than half, depending on the definition you’re using.

But asset flows suggest users are generally sticking with plain vanilla equity ETFs, which took in 75% of 2018’s investment money. Of the nearly $4 trillion in ETF assets under management, smart beta ETFs account for a total of $905 billion in AUM.

2019’s flows may be different. The first quarter saw two smart beta ETFs—the iShares Edge MSCI Min Vol U.S.A. (USMV) and the Invesco S&P 500 Low Volatility (SPLV)—garner the lion’s share of flows.

Flows explain where ETF money is going, but not necessarily who’s using these strategies. Recent data is conflicted on that topic, with two recent surveys seemingly pointing to different results regarding how financial advisors use the strategies.

What’s really going on? Market watchers say financial advisors’ use of smart beta mirrors their stance on ETFs as a whole: First they learn about the vehicles and get comfortable using them, then they may explore additional offerings. But these market watchers also say advisors may be wary of the more complex strategies, which limits greater adoption

Surveys Say …
The 2019 Global ETF Investor Survey conducted by Brown Brothers Harriman (BBH) with shows 92% of U.S. respondents have at least one smart beta ETF, with 26% of them using it to replace an actively managed mutual fund. Respondents say they’re looking for more active and smart beta ETFs, too. Of the 300 respondents, 50% were financial advisors.

Shawn McNinch, head of U.S. sales for BBH, says the survey results that most stood out reflect the growing importance of costs, as smart beta ETFs are cheaper than mutual funds, and that advisors are starting to look at past performance of a fund, which is usually an active filter.

“Some of your traditional screening criteria could be coming into play with smart beta as well as active ETFs, as more and more fund managers come into this space and start launching active ETFs as well,” he explained.

Meanwhile, a March survey of 350 advisors by Cerulli Associates found that only 21% of advisors were using smart beta strategies. Survey authors say ambiguity about factors and what these strategies intend to accomplish appear to be discouraging greater implementation. Daniil Shapiro, associate director at Cerulli Associates, says that figure was a surprise, but he also notes that some advisors don’t consider the ETFs they’re using to be smart beta, and instead are classifying them as active.



“We believe [advisors] are having trouble differentiating between strategic beta and active management,” Shapiro said. “If issuers are really diving into the rules and explaining how the product changes in regard to a specific kind of market condition, it’s possible they may make it sound like it’s an active ETF … . Issuers should be focused on educating about the outcomes the products are supposed to achieve, as opposed to a highly technical explanation.”

Elisabeth Kashner, CFA, director of ETF research at FactSet, says advisors aren’t the only users of smart beta strategies; a variety of institutions also use the funds. She pointed to the $25 billion USMV, which showed 67% institutional and 33% retail ownership at the end of the first quarter. The biggest portion of the institutional category are financial advisors, who held 46.8% of the shares outstanding as of Dec. 31, 2018.

Whether advisors use smart beta strategies may depend on how they position themselves to clients, she says, particularly if they market themselves as an investment expert.

“That kind of a story is very difficult to tell if your port-folio contains funds like the Vanguard Total Stock Market ETF (VTI),” she said. “There’s a certain type of marketing strategy that requires complexity, and in many cases, the suggestion of risk-adjusted outperformance over time. For that business, smart beta is actually a pretty good fit.”

Twofold Appeal
Todd Rosenbluth, senior director of ETF research for CFRA Research, says appeal for smart beta users is both  for those who were already comfortable with plain vanilla ETFs and want to reduce their risk profile or enhance returns to complement existing ETF asset allocations; and those who’re shifting from costlier actively managed mutual funds to cheaper and more transparent smart beta ETFs.

But for those who haven’t tried smart beta ETFs, what keeps them away? Rosenbluth doesn’t think it’s cost versus plain vanilla ETFs, as there are many smart beta ETFs, like those from BlackRock or Charles Schwab that charge 20 basis points or less. Rather, he sees need and complexity behind advisors’ reticence to switch.

“If you’re an advisor running an asset allocation strategy, there’s little wrong with a market-cap-weighted approach and keeping it simple,” he noted.

Cerulli Associate’s Shapiro concurs: If an advisor has to explain why the multifactor product she used significantly lagged the broader market, the complexity of these ETFs may mean that more than one thing caused underperformance, complicating explanations.

Tyler Cloherty, senior manager at Casey Quirk, says advisors could be hesitant to use smart beta ETFs if it’s not easily obvious “what’s truly driving the value behind those strategies and whether or not it actually makes sense in terms of the long-term investment philosophies.”

David Schneider, founder of Schneider Wealth Strategies, says when using these ETFs, he sticks to the basic factors, such as size and value, since the academic research backs up those strategies: “I’m more comfortable with those factors on a long-term basis,” adding that he uses these to capture potential outperformance.

Underperforming Outliers
FactSet’s Kashner says so far the achievement aim of smart beta strategies might not be working out. Looking at risk-adjusted performance calculations over about the past eight years, she says the overwhelming majority of funds perform in line with the risk taken, while the outliers are more likely to underperform—and a very rare few outperform.

That’s not to say advisors haven’t found legitimate needs for them. Craig Bolanos, CEO of Wealth Management Group, says he uses low-volatility funds to reduce a client’s equity portfolio risk.

“There are a lot of rational investors who desire the typical balanced portfolio—50% stocks, 50% bonds—who can’t bring themselves to allocate 50% of their portfolio to bonds when the 10-year Treasury is yielding so little,” he said.

CFRA’s Rosenbluth says the increased use of smart beta strategies may be from institutional issuers using them in-house. While that might speak to the lack of broad adoption, he suggests the fund family may be using the ETFs as a way of getting exposure to the approach instead of using mutual funds. One example of likely institutional use is the jump in assets in the John Hancock multifactor products, Rosenbluth adds.

The flows into risk mitigation smart beta ETFs likely reflect the current market conditions as a way to diversify portfolios, instead of just looking for market-cap returns, BBH’s McNinch says.

Bolanos says he’s concerned some advisors have unrealistic expectations for some factors like low volatility during market dislocations. He says by using an ETF like USMV, he reduced drawdowns during the fourth quarter sell-off, and the ETFs performed exactly as he expected: “If the industry lost 20%, and I lost 13%, I consider that a hell of a win.”

Debbie Carlson focuses on investing and the advisor space for U.S. News. She is an internationally published journalist with bylines in publications including Barron's, Chicago Tribune, The Guardian, Financial Advisor, ETF Report, MarketWatch, Reuters, The Wall Street Journal and others.