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. Are ETFs allowing institutions to be more tactical than before? Is tactical asset allocation more of the norm today among institutions?


Hunnicutt: It depends on the institution and how much they may make tactical decisions inside of their allocations. A hedge fund, for example, has to do things much differently than a large insurer or an endowment. But I do think that there are folks who are starting to consider and evaluate the potential opportunities in being more tactical because the tools to do so—ETFs—are now available.


I think smart-beta ETFs also allow you to have some specific outcome-based types of opportunities. If I'm a pension plan and I want to lower my risk, I can do that by using a low-volatility equity basket versus just buying bonds, particularly given where the rate environment is right now. Smart-beta ETFs give me more options. Is there a particular type of smart-beta ETF that institutions are favoring these days?


Hunnicutt: Fundamental weighting is one type we've seen people have interest in. And it's been around for a while. Having a longer track record in these strategies helps. PRF [PowerShares FTSE RAFI US 1000 Portfolio (PRF | A-88)], for instance, is nearly 10 years old now. Institutions like the fact that they have a significant track record they can look at.


But smart-beta ETFs all have personality. You can look at something like a momentum-weighted index versus a high-quality index. The market environments in which they perform and add value are going to be different. All of that impacts their adoption rate. The report pointed out that high-dividend funds are among the most widely used today. Is this just a phenomenon that's tied to the ongoing hunt for yield?


Hunnicutt: What we hear most often is that yield is a lot more scarce today than it was 10 years ago. Institutions are trying to find ways to help re-factor some of that income or that dividend. Certainly, dividend-paying stocks or a basket of dividend-paying stocks is a way that they're able to do that.


Dividend strategies have also been one of the earlier types of smart-beta tools to come out. So, maybe they've had a little more time to get traction and to show how to perform in different environments. I’ll say that the length of time on the market as well as the current yield environment are two factors leading institutions to have a high interest in dividend-focused ETFs. Did anything surprise you in your research as far as how institutions are using smart-beta ETFs or what types of funds they favor? Any shocker?


Hunnicutt: Compared to the report we did last year—this was our second annual—there wasn't a significant change in outcome. We were very encouraged to see the level of interest in and increase usage of ETFs in general. But it was interesting to see that smart-beta ETFs are the type of vehicle most institutions say they intend to use more of. Some 62 percent said they plan to increase use of smart-beta ETFs, more than any other category. And that number is up from last year. We expect it to grow further. Is there any pocket of the market where institutions see a need for product innovation? Are there any flavors of smart-beta ETFs missing?


Hunnicutt: There’s a push for multifactor ETFs, although we're already there in many cases. If you look at SPHD [PowerShares S&P 500 High Dividend Portfolio (A-53)], that’s a great example of taking two factors to create a unique outcome of high-dividend-paying stocks that have less volatility. But I think we’re going to continue to see similar funds evolve that combine things like factors and strategies.


There's a lot of interest in the current environment around currency-hedged-type products. Smart-beta ETFs that incorporate a currency hedge with better tactical factors could be an area where people might have real interest. 



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