Axioma’s Brown On The Future Of Smart Beta

September 13, 2016

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. 

 

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