Legg Mason ETFs: Smart Beta Is New Core

February 17, 2016

There’s a changing view on where smart beta belongs within an investor’s portfolio. More and more, these nonmarket-cap-weighted strategies are finding their way into the core, and that’s great for a company like Legg Mason.

The firm, which recently brought to market four ETFs—three of them “diversified core” and one a volatility/dividend fund—is behind the notion that smart beta is the new core.

We recently caught with Portfolio Manager Mike LaBella and QS Investors President James Norman to talk about Legg Mason’s view of the world. QS Investors is the subadvisor for the Legg Mason ETFs.

ETF.com: You are subadvisors to the Legg Mason ETFs. Tell me a little bit about the clusters and correlations that are at the center of the methodology. What are these funds attempting to do?

Mike LaBella: There are two suites of ETFs we launched. Three of the ETFs are what we call diversification-based investing. The idea is that country and sector are big drivers of equity returns.

If you look at the S&P 500 last year, it was flat. But if you were in energy, it was down 25%, versus consumer sectors that were up 10%. Also, the DAX was up 10%; Japan was up 10%. So, the country and sectors really mattered.

This approach tries to take that macro exposure and diversify it, because cap-weighted indices can be very concentrated. If you look at international market indices, two countries—Japan and the U.K.—represent almost 50%. If you look at what's going on in emerging markets, BRICs [Brazil, Russia, India, China] dominate exposure. Investors are missing out on all these other opportunities. So the strategy tries to identify relationships between those countries and sectors, and diversify that risk.

We also have the low-volatility, high-dividend strategy. That strategy is designed for investors looking for more income.

ETF.com: This clustering based on correlation is the way you go about diversifying risk?

LaBella: That's right. The way you look at it is, if you have two countries in the international space, you look at Australia and you look at Canada, do they behave the same way or are they different? Both those economies are very commodity-sensitive. Commodities have struggled. And we've seen both their economies behave very similarly.

So the clustering process just looks at market risks through correlations. It says that Canada and Australia are kind of the same in that regard. It does the same thing in other markets; if you look at Brazil and Russia, same thing: They have a high correlation.

ETF.com: Are investors ready to slice and dice countries other than the U.S. by sectors, such as own China retail and tech rather than own broad China equities?

LaBella: For an investor who has a particular view, we see that you can go out for individual country funds and you can manage that exposure. But that's not the average investor. We think the average investor is just trying to get broad asset class exposure, whether it's international or it's emerging market. They're not sitting there doing country-specific research and saying, “Now's a good time to be in China and a bad time to be in India,” or vice versa.

What this approach does is help them manage that process. You want EM exposure because EM exposure is different than your S&P 500 exposure. But you don't know which countries to allocate to. And rather than just leave that up to arbitrary size, why not take into account how these behave?

So, when the China ecosystem collapses, like it is right now, you're invested in things like Eastern Europe and Turkey that aren't as connected to that China system. These have actually held up pretty well.

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