Axioma’s Brown On The Future Of Smart Beta

The smart-beta ETF industry has long been centered on asset growth and new, innovative products, from single-factor to multifactor and beyond.

But do investors really understand how these products work? And most crucially, how can investors compare products and evaluate performance?

Melissa Brown, senior director of applied research at risk management and portfolio construction firm Axioma, says the new wave of smart-beta evolution will be focused on comparing smart-beta performance to a benchmark, just as investors are used to doing with other funds.

Investors can catch Brown’s keynote speech on the future of smart beta at the Inside Smart Beta conference in New York on Sept. 22 and 23.

There is a true plethora of smart-beta and risk-factor ETFs on the market now. That fact alone must make it difficult to know how to pick the right product.

Brown: You have various types of smart-beta portfolios that sound very similar but are in fact very different, or you have portfolios that sound very different but are very similar.

For example, if you take two high-dividend-yield ETFs, the names may say “dividend yield,” but they will have very different sector weightings, different names and concentration of those names, etc. And if you compare a group of high-dividend-yield ETFs to a group of low-volatility ETFs, they’re actually very similar [in their makeup], apart from the dividend yield.

The bottom line is you really need some kind of benchmark—not the one the ETF provider creates for the fund to target, but a broader, more generic benchmark for the market you want to track. It’s not about saying what’s right and wrong, but the benchmark will help inform you of the differences in ETFs’ performance.

So even comparing a U.S. equity risk-factor ETF to the S&P 500 could be helpful?

Brown: Yes, but you’re not looking for a generic market benchmark; it’s one that somehow reflects what your ETF is trying to achieve.

We propose the future of smart beta will be about evaluating performance, rather than discovering new products and factors. I don’t know how many “new things” are out there to exploit anymore. In terms of factor ETFs, maybe a provider can find some niche industry and create an ETF there, but that’s not where the assets are going to come from.

How do investors take that first easy step to evaluate performance?

Brown: I don’t think there’s an easy step to doing it. Somebody will have to create those benchmarks, deciding what defines them and then creating them. That’s not something you can do tomorrow.

My presentation [at the Inside Smart Beta conference] focuses on a few ETFs through the lens of a risk model so you can get a sense of how they’re similar and different, but we don’t suggest which benchmark you use. 

Are we a long way off from those benchmarks being applied to other areas, e.g., smart beta within fixed income or within ESG?

Brown: As for entering other asset classes, we’ve learned a lot over the last 40 years in terms of benchmarking, but I think the vast majority of smart-beta assets are in equities, so that’s probably where that new process will start.

Like it has been for asset management over 40 years, it’s going to be a bit of an evolution, but I think in this case, depending how we define the rules, it may not be so difficult to create benchmarks. We already have benchmarks for [nonsmart-beta ETFs], so it’s not like we have to create them out of thin air.

And once we start to accurately judge smart-beta performance, will that have some kind of shakedown effect on the wealth of smart-beta products on the market?

Brown: Personally, I think the shakedown is going to come whether or not those benchmarks are created. There are only so many assets to go around. I’m not sure I understand the economics of creating one more ETF of which there are already 40, or creating something that doesn’t exist, as there’s got to be some reason that it doesn’t exist already.

In saying that, there are so many ways to define ESG [environmental, social, governance], for example, and investors have different views as to where they want to focus their investing.

But I do think that, by creating this benchmark, it could provide a shakedown of some sort—if an ETF is calling itself something different in the future, it will really have to outperform the other funds to survive.

Will the benchmarks have to change as investor trends and fads change?

Brown: I think the nature of creating rules for benchmarks is they need to evolve, in the same way that the S&P 500, the Russell 1000 or the MSCI World Index all evolve over time. Therefore I don’t think these [new, smart-beta] benchmarks will become obsolete.

Is there a lot of education still needed regarding smart beta?

Brown: There always is. Certainly this issue is no exception. You hear stories about brokers recommending strategies and they have no idea what’s in them. So when things go pear-shaped, they can’t respond in the right way. If you have a benchmark, you can analyze what’s gone right or wrong, whether a certain category of stocks has performed, for example, or if the ETF has outperformed its peers.

I think there’s a lot of education needed for the financial advisor and investor community. I’ve been working in this business for a really long time, and it’s gotten a little bit better, but not dramatically so.

Too often people just buy recent performance. That’s not new, but it’s important to understand that recent performance and determine whether that will continue or reverse.

But isn’t past performance more accurate with passive funds, as they are rules-based and don’t depend on human decisions like active funds do?

Brown: Yes that’s probably true. But I’m not completely convinced that just because something is rules-based means it isn’t active.

Let me explain: What can I do with my money? I can put my money in an index fund or I can invest in a strategy that’s expected to beat that index fund, and the latter is active, regardless of whether it’s rules-based or whether it’s an active manager going out and visiting companies and selecting stocks.

The expectation is that strategy will beat the market. Otherwise, why would you pay the higher fee?

Indeed, I’ve often asked why smart-beta ETFs tend to cost more than plain vanilla when they track an index. Is it because there’s a lack of competition?

Brown: Look at many of these smart-beta categories—there’s no lack of competition there. Again, it’s not to say nobody could create something new, different and useful, but the rate of growth there has slowed way down.

Who is likely to use these new smart-beta benchmarks?

Brown: In the ETF category, some of the newer entrants of investors are pension funds. They need a benchmark to evaluate performance. They already do that for their other investments. That may be the first wave of people who use a generic smart-beta benchmark.

Look at the pension fund in Norway—they may not be investing in smart beta via ETFs, but it’s already happening in some form. Yet there are more and more pension funds looking at that idea [risk factors within ETFs] because it seems to be cheaper than hiring a bunch of asset managers which will hopefully lead to better performance.

Who else will use the benchmarks? In terms of individual investors, I don’t know. There’s a lot of fad-chasing going on. I happen to believe these factor-type strategies are what you should be doing in the long run, but if there’s a period of bad performance, I think a lot of people will move on to the next thing.

So you’re a fan of multifactor funds?

Brown: In the interests of full disclosure, I spent a long time as a quantitative manager working on multifactor models. The benefit of that strategy is you diversify the risk that one particular factor is not going to work. If you had perfect foresight as to what’s going to do well and when, then you pick single factors. If you don’t, which most people don’t, multifactor strategies diversify and alleviate risk—and that will come with a higher fee.

For fad-chasers, how can they go about allocating to smart beta in a sensible way and judge performance?

Brown: Like anything, you have to educate yourself. The ETF providers do provide fact sheets and talk about the characteristics of their funds. But it’s difficult to know how to combine several single-factor funds.

That’s where I would hope for financial advisors to come in, for the wire houses and RIA-type advisers too, and that there’s some kind of software that takes, say, three funds, and analyzes their characteristics. I mean, if I buy five different factor funds, I may just be getting the index anyway, so why pay the fee for all five of them?

In that case, the fund is labeled “multifactor,” but it looks suspiciously like the market. I think a lot of these multifactor strategies are not trying to hold 400 stocks and beat the S&P 500, however. It’s more like 100 stocks, and on balance, they’ll have exposure to momentum or to value or to profitability and they’ll differ from the market in that way.

Melissa Brown, CFA, is senior director of applied research at Axioma.