Smart Beta Comes Full Circle

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

Smart beta strategies are evolving, and newer ETFs from Vanguard and BlackRock appear to blur the lines of what were strictly passive vehicles.

Originally, smart beta strategies sat between plain vanilla, market-cap-weighted indexes and actively managed funds, taking the rules-based approach of indexes and adding a filter to tilt the strategy to express a factor, such as quality or size.

But with the newer factor-based quantitatively managed active ETFs, smart beta may be morphing into something a bit different.

Another Look
Vanguard’s suite of six actively managed factor ETFs debuted in February 2018, with the Vanguard U.S. Multifactor ETF (VFMF) having the largest assets under management (AUM) at $86 million. The funds are actively managed, but the portfolio manager follows a rules-based process to select and weight the securities. The portfolio manager rebalances the fund as they see fit to conform to the factor.

The BlackRock U.S. Equity Factor Rotation ETF (DYNF) launched in March. It’s an actively managed fund that uses momentum, quality, value, size and minimum volatility to select stocks, and also will emphasize which factor might do better based on manager discretion using four economic and technical indicators.

Ben Johnson, director of ETF research at Morningstar, considers these actively managed ETFs “a natural evolution” in terms of smart beta product development.

Matthew Jiannino, head of quantitative equity product management at Vanguard, says the innovation with its ETFs is to get advisors from thinking about style boxes for portfolio construction to using factors instead, and to give advisors risk models and tools so they can get as much targeted factor exposure as they want.

“To us, that’s when it—not the smart-beta world, but the factor world—really starts to take off, because now investors can use factors … in existing portfolios,” he said.

Andrew Ang, head of factor investing strategies for BlackRock, calls DYNF the “absolute future of factor investing, which is to put more active insight into all of our investments.”

Just as hedge funds and other institutional traders use factors to time investments based on economic or technical chart signals, BlackRock seeks to do the same with DYNF.

“This is the best embodiment of being active with factors,” Ang explained. “It packages active management and insights, and delivers it through an ETF. It’s an entirely active approach, and that’s why it’s new.”

Next Frontier?
Both Morningstar’s Johnson and Chuck Self, chief investment officer at iSectors, say the Vanguard products contain the DNA of what firms like Dimensional Fund Advisors created with their factor research, and both say they aren’t sure if those ETFs are really making significant leaps into new territory.

“They’re a close cousin to what some asset managers label a ‘systematic active equity’ strategy,” Johnson said. “It’s an approach to portfolio construction that’s been supplied by firms like Dimensional Fund Advisors or AQR for decades.”

Jiannino says Vanguard’s approach goes back to the firm’s active management approach: “We’re using a lot of the similar signals based on academic research. A lot of them are well- known, but we said if we would build our own factor products, how would we do it, and a lot would be tied back to us as active managers.”

Vanguard says it mixes the transparency of rules-based selection with a portfolio manager who can rebalance as needed. Brett Manning, senior market analyst at Briefing.com, says to determine whether a fund is the next evolution of systematic smart beta ETFs, investors need to ask if something like advanced artificial intelligence could replicate the manager’s activity.

“If it can, then I think this still falls in the smart beta niche,” he noted.

Manning says he worked in systems development for the futures industry, and says by adding a single discretionary element, “it changes the nature of the game completely.”

At that point, it becomes a question of who the fund’s managers are and their tendencies, rather than the systematic strategy, he says.

While Johnson says the Vanguard ETFs aren’t anything significantly unusual in the smart beta world, he believes that DYNF from BlackRock is a different animal entirely.

DYNF is actively trying to time exposure to factors, which brings a level of complexity to a style of ETF that’s already known for not being well understood, Self says. The timing element makes the fund more akin to true active management than what the Vanguard funds seek to do.

Johnson says he’s skeptical that this strategy will outperform over the long run.

“There’s no real evidence that shows that any of the various measures that managers have attempted to use, at least looking at history, to reliably try to time factor exposures, have worked all that well,” he said. “There’s less reason still in the belief that any of these might work on a go-forward basis.”

Timing Factors
When it comes to something like DYNF, there’s also a question if timing factors doesn’t change the whole point of smart beta, which says academic research shows certain factors like size, value and quality can outperform over time. It’s why there’s a premium to invest in individual stocks with these characteristics.

“This is an attempt to cater to our very short attention spans,” Johnson added.

But Ang counters that’s really the point, trying to take advantage of the different time horizons to generate returns: “We have the long-term performance of factor strategies … but now that we have active insight, we’ll add an additional degree of outperformance by rotating those factors based on [our] indicators.”

Whether these funds are the future of smart beta or factor investing, some advisors remain wary of complex smart beta funds.

Kristian Finfrock, founder of Retirement Income Strategies, says he uses some smart beta ETFs for both alpha generation and risk management, but that he’s a little skeptical of some of the new, more complex smart beta ETFs. While evolution and product design “is good and necessary, some of it seems to be a creative marketing strategy,” he said.

Self says these newer strategies haven’t pulled in the AUM. Although DYNF is only a few months old, the Vanguard suite is over a year old, and the biggest fund by AUM, VFMF, only has $86 million in it.

“It doesn’t seem like the world is beating down the doors to buy it,” he noted. “What it comes down to is the more complicated it is, the harder it is for investors, even for people like me, institutional investors.”

Vanguard’s Jiannino admits advisors need to be better educated on how to use factors: “It’s not just about products, but how to think about factors. The other piece of this is getting people to understand how you go about evaluating these things.”

Self says he’s taking a wait-and-see approach toward DYNF, saying it’s too early to crown the ETF as the future of smart beta. He’s not sure if people will be willing to pay 0.30% for active management, when there are cheaper indexed dynamic multifactor funds with Invesco and PIMCO.

“I want to wait and see how his fund does in a bear market before deciding whether this is going to be the future of smart beta,” Self said.