ETFs' Future: Huge Growth

February 04, 2014

Half Of ‘Smart Beta’ Is Probably Junk

A few years ago, we didn’t even use the term “smart beta,” but the idea has been around for a long time. Go find a bunch of factors, use them in your weighting and selection techniques, build a model and wedge them into an index.

In the 1990s, we just called these quant strategies. Now we call them “smart beta.” We dedicate an entire upcoming issue of the Exchange-Traded Funds Report to these funds, and in it we highlight a few big issues.

The first one is crowding. For a few years, it seemed like buying the less risky stocks in the S&P 500 paid more than buying the riskier stocks. That goes against the fundamental math of the capital asset pricing model, so it was called the “low-vol anomaly,” and people piled into products like the PowerShares S&P Low Volatility ETF (SPLV | A-47) … until it stopped working.

Why did it stop working? Likely because everyone piled in, and once everyone had finished piling in, those stocks went back to just performing like they should—the sleepy part of the S&P 500. These are not bad products, but investors need to understand what they’re buying.

One concern that is more worrisome: Strategies that try and beat the market generally incur increased trading and execution costs. That shows up in bad tracking, which can add insult to injury in products that are often multiples more expensive than vanilla indexing.

Last, many of these products simply don’t trade well, and as theoretical “buy and hold” alpha generators, they can trade at significant discounts and premiums based on flows.

We’re not saying no smart-beta product is any good. We’re just saying it’s a giant “buyer beware” area of the market.

Pay To Play

But if half of smart beta is junk, at least you can avoid it. Far more pernicious are the trends we’re seeing in the pay-to-play space.

Let’s start with the obvious. Zero commission doesn’t mean zero cost. Discount brokers aren’t creating and running commission-free programs for their health. BlackRock/iShares, State Street Global Advisors, PowerShares and everyone who is participating in these programs is paying money to the brokerages to do it, in some form or another. And while we haven’t seen fees going up yet in the ETFS offered under these programs, it’s worth keeping an eye on.

What’s worse is what we see happening to the recommended lists at major broker-dealers and institutions. There was a time—and this is still largely true—when these lists represented the true best thoughts of the people in these firms.

But these lists drive assets, and there’s increasing chatter in the industry about deals—whether through direct payments, revenue sharing or other means—for ETFs to get onto these recommended lists or into unified management account programs. It’s a very worrisome trend, because it means the best choices may not rise to the top.

And finally, for as much as we love the ETF strategist revolution, all those trail fees are taking us a little bit back into the mutual fund era, where you get what you pay for.

A survey of the portfolios of ETF strategists shows everything from well-thought-out asset allocation programs to shoot-the-lights-out market-timing bets that flip flop between levered positions.

In other words, it’s the same diversity of sanity and talent you’d expect to find in any large collection of managers. There’s nothing about bolting “ETF” on the front of your active management strategy that will make it better.

 

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