Smart Beta ETF Adoption Slower Than Expected

February 01, 2017

Deborah Fuhr, managing partner of consultancy ETFGI, is widely respected in the ETF industry for her deep expertise and insight into all things ETF. In a recent sit-down with us, she offered her take on the current state of the ETF market, and what she sees happening ahead. What are some of the most important trends in the ETF market right now?

Debbie Fuhr: If we look at 2016, we had record levels of net new asset inflows globally and in the U.S. We’re at a global record of $3.5 trillion. We've seen 35 months of positive net new assets going into ETFs—that’s basically three years. I can't think of any other product over the past three years that would be able to say that.

We also saw a lot of new launches last year, but not a record year. We did, however, have a record year in the number of closures globally and in the U.S. Many firms are trying to decide what the right family of products to have is. And there’s been a lot of fee pressure.

Among the launches, there's been a lot in the smart-beta space. But what’s interesting is that smart beta has grown, but probably not at the rate people would’ve expected. The issue is that smart beta’s not really clear. The asset management industry doesn't speak about what smart beta is with a clear voice.

Some people think it's index, some think it's active. There's no agreement as to which factors are smart beta. About 33% of the assets in smart-beta products are sitting in dividend products—which, for most investors, is not smart beta at all, but an income play.

As we move to multifactor and even single factor, the challenge for many is, “how do I use this in my overall portfolio?” People should understand that factors are designed to deliver better-than-market-cap returns over very long periods of time. But you could have multiyears of underperformance. We have to be careful to be clear about what we’re really measuring here.

As an industry, many of the new firms looking at launching ETFs are thinking about whether they should have their own ETFs—what’s their strategy? They’re looking at digital and automated advice. They’re looking into whether to partner up with someone else, or whether to acquire. We’re going to continue to see entrants into the space take many forms.

From a regulation standpoint, my believe is the DoL [Dept. of Labor fiduciary] rule may be delayed, but it’ll increase the use of ETFs, because the compliance means that small accounts will likely be pushed to automated services as opposed to being covered. And the move toward providing products that are in the best interest of the investor and are reasonably priced will also be a positive towards ETFs. What’s driving asset inflows? Is it new money coming in from investors using ETFs for the first time, or is it that ETF investors are increasing their allocations?

Fuhr: When we see someone use an ETF for the first time, it's often a pretty small trade. And it's a test. The trend has always been that once people try it, they tend to use more. They tend to invest in larger sizes. And they tend to hold for longer time horizons.

In the study in which we look at who the investors are, we see that over 8% of the 4,000 institutions using ETFs hold over 100 ETFs. That's been an increasing percentage of institutional users. The trend is to go up in number of products, in assets and in time horizons. It's easier to sell more to someone who's already decided they like ETFs, and it can take a long time to get someone interested in trying ETFs for the first time. But we are seeing that happen also.

So, it's a mixture of more from existing and more new clients. And we see regulatory changes happening outside the U.S., where advisors—similarly to the DoL—are seeing regulations change, where they no longer can be paid to sell products, or transparency around fees, removing the fee structure. Changes are happening in Canada, in Europe, in Asia. That's really pushing advisors to use ETFs for the first time. Will the mutual fund industry do anything aggressively to compete with ETFs, or will mutual fund providers just launch ETFs as a way of having both?

Fuhr: People realize there are some benefits to ETFs, but some challenges as well; for example, the defined contribution 401(k) space. Right now, it's not easy to do fractional share ownership. The 401(k) products tend to use end-of-day pricing, so the way ETFs work with commission and trading doesn't naturally fit within that. I do think there are times where mutual funds make sense, times where segregated accounts do and times where ETFs do.

For most firms, it probably makes sense to be able to offer across the line. But the big challenge is getting the compensation model so that your salespeople know how and when to sell everything, because it's easier to prove you sold mutual funds than it is ETFs at the end of the year.

That means we're going to see firms embracing ETFs, but maybe just for smart beta. Or there are those who wonder whether the regulatory change will allow nontransparent active or whether issuers will go down the route of doing exchange-traded managed funds, which the SEC has said shouldn't be called ETFs. There are a lot of possibilities here, and a lot of possible regulatory change. Smart beta is talked about all the time now. But in your view, has adoption of smart beta been slower than expected, because of the lack of a clear definition or an industry consensus?

Fuhr: It's still unclear to many people who might try using a smart-beta ETF what smart beta is. Is it active or is it index? Because if it's active, and I'm a gatekeeper, I want to see three years of track record and $100 million in assets. If it's an index product, my threshold might be one year and $75 million.

What are the factors? Many of the index providers don't agree that yield or dividends are smart beta. Others do. Some say that using a currency-hedged market-cap product is smart beta. Others don’t.

And then the way they calculate the indices is really different. If you look at the calculation methodology of large index providers for momentum or quality, minimum variance, etc., you'll see it's all very different. That causes confusion among investors.

It’s difficult to do your due diligence and decide how to use it if you don’t really know what it is. It's about the education, so investors can understand how and when to use it, and how to fit it into their overall portfolio construction methodology. Does that mean that the bulk of ETF asset growth is still going to be on plain-vanilla passive ETFs, because they’re easy to understand and to build portfolios with?

Fuhr: I think both will. But, increasingly, ETFs have become more cost efficient than using futures. There you're using market cap to equitize cash—that’s obviously a driver. And many people who use ETFs to build multiasset class portfolios are using market-cap products to do tactical asset allocation and get alpha from that. Robos tend to be only using market-cap products as well.

Look at the one of the most successful products ever since it was launched—it’s the first ETF in the U.S., the SPDR S&P 500 (SPY). People still use it in very significant ways: long term, short term, tactical.

Think about it: Every day, 10,000 people turn 65 years old in the U.S. They're going to robos or automated advice to do their homework. And all of those tools have market-cap products in it. It's easy to relate to, because what does the Wall Street Journal talk about? It talks about the S&P 500 and all those mainstream indices.

For many, if they're doing it themselves, that's very easy to find. When you start looking at other indices—smart beta or whatever—it's harder to find out what its performance is, how it works, when and how you should use it, and how much. But I believe, as people understand what smart beta is, they’ll use them more.

You have to remember that, for asset owners, how they get assessed is market-cap benchmarks. Other things that are more thematic or smart beta are tilts towards or away from something as opposed to a core holding. There's a space for both. My last thought is about innovation. Do you have a prediction on whether 2017 will be the year we see a bitcoin ETF?

Fuhr: I've been following bitcoin at kind of a higher level. Part of the challenge is that some countries don't allow investors, or anyone, to invest in it. The tax consequences of owning bitcoins are unclear in many jurisdictions.

I also think many investors are concerned because you see how you could lose your computer and lose your bitcoins. There are some concerns about a number of things that have been in the press about trades happening or bitcoins going missing, or other issues around bitcoins—it’s not yet mainstream.

The SEC has had some concerns around it. I don't have a personal insight as to whether they will approve it, but I’d say it’s likely we might see—and we have seen—bitcoin products come out in other structures that aren't ETFs. ETFs may not be the first way they come to market.

Contact Cinthia Murphy at [email protected]


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