Institutions Fuel Smart Beta ETF Liquidity

May 07, 2015

More and more institutional investors are using smart-beta ETFs, according to Invesco PowerShares’ second annual study “The Evolution of Smart Beta ETFs.”


Conducted in partnership with Market Strategies International, the study found that more than one-third of institutional investors—including public and private pensions, endowments and registered investment advisors—are now using smart-beta ETFs. About two-thirds of them say they plan on using more of these funds to access specific factors and strategies in a cost-effective way.


Why does this matter? Because the growing adoption of smart-beta ETFs among institutions is helping fuel liquidity in many of these funds, Mike Hunnicutt, head of institutional ETF sales at PowerShares, tells us. Your latest research into institutional use of ETFs found that institutions are using smart-beta ETFs more than ever before. Is the pace of adoption faster than you’d expect, or is it in line with how quickly institutions were to embrace other types of ETFs?


Mike Hunnicutt: That's a great question. Maybe what’s new here to some people is the term “smart beta.” Many see as a new phase this concept of nonmarket and noncap-weighted rules-based passive investing. But even though it seems like things have evolved here very quickly, this is something that has been around for quite a while. PowerShares has been offering these solutions for over a decade now.


Now, I do think people are becoming more aware of it. In the first stages, investors needed to get comfortable with ETFs as an investment vehicle, and then they started to pay attention to the various methodologies beyond market-cap-weighted that might be useful in portfolio construction.


That's one of the main reasons we wanted to do this study—to find out what institutions' views are on smart beta and see how they are able to use them effectively in their portfolios. Do institutions see smart beta as a form of active management?


Hunnicutt: That's a question that comes up a lot—is smart beta passive or active? The right answer is it’s both, because you’re getting benefits from both sides. You get the ability to provide some type of value-add component, whether it be for some type of enhanced return opportunity or through risk reduction, but you're also getting it in a low-cost, daily, transparent, rules-based format.


The traditional two-bucket portfolio construction—where you have pure-beta passive exposure on one side and true active management on the other—now has a third bucket, which is smart beta.


Yes, opinions still diverge on whether smart beta is active or passive management, but generally, we’re hearing a lot more institutions just look at it as a bucket all its own, right in the middle. What are the main reasons institutions are turning to smart-beta ETFs?


Hunnicutt: One of the benefits of smart beta is that it's passive indexing with a purpose. So if you want to take less risk in your equity exposure, you used to have to go through an active manager for that. Today you can use a low-volatility basket of stocks that can get you similar exposure.


Institutions are interested in the sense that there are tools that allow them to take a very specific perspective in their portfolio, whether they want to have more exposure to momentum stocks, or a bigger mix of high-quality stocks or dividend-paying stocks. It allows them to be very specific about how they want to tilt their portfolios in ways that may have been more difficult to achieve before.


The other side of that—coming out of the financial crisis—is that there's a higher level of interest around liquidity. When you look at some of these tools, their liquidity may make them more convenient to make tactical changes on an allocation than using something like a separately managed account or a mutual fund.


They can also be less expensive tools. Asset managers typically don't like tactical changes that allocators make because they drive up cost and that has potential tax impacts on all the other owners in a mutual fund. But because ETFs trade on the exchange, they don't have that impact.


ETFs are a very effective way to make tactical changes inside of an allocation.


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