Legg Mason ETFs: Smart Beta Is New Core

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.

ETF.com: Why come to the ETF market now? Was it client demand?

James Norman: Absolutely; it's client demand. We've been managing these smart-beta strategies for large institutional clients for the last 14 years. And what we really saw is that the same things we were hearing from those large institutional investors and why they invest in these types of strategies, now we see with a lot of retail investors and advisors. They’re realizing there's a lot of concentration risk and a lot of biases in market cap, and they’re not as diversified as they could be.

Recently, a lot of the focus has been on single-factor strategies to try and do that; buying a defensive strategy through low volatility, or something else like that. But now I think investors are moving more toward saying, “Let me fix the core; let me add something in that will diversify where I have most of my money, which is the market-cap-weighted index. And if I can find a better way to get that equity risk premium to capture that return in emerging markets, in a more diversified way and not expose myself to one or two countries that are just so large, that if they're doing poorly, just really pull down my returns, it's a much more effective way.”

I think really you've had that evolution of something moving from the institutional space into the retail space as well.

ETF.com: So this is about rethinking the core.

Norman: We're moving from a period of people thinking about smart beta as a way to tilt a portfolio to really solving broader problems within investors' portfolios—the bigger part of their portfolio, the market-cap index, or active managers that are similar in terms of many of the weights to market-cap index.

With that change, that's going to cause even more money to go into smart-beta strategies, and that's where we think a lot of the ETF growth is going to be. That’s outcome-oriented investing—that’s where we're going to see a lot of the growth. And ETFs are a great tool to do that.

ETF.com: In your recent market insights for 2016, you pointed out two themes: the Japan opportunity and the QE risk. First, tell me your views on Japan—is Abenomics going to work?

LaBella: Rather than choosing if Abenomics is going to succeed or fail, know that Abenomics is going to have a significant impact on the Japanese economy. That's why investors have to be diversified. That's our whole outlook in international markets.

Right now, Japan is a massive weight in broad international index. So we want investors to have that exposure because country dispersion is only going to increase in 2016. There’re changes in monetary policy. Japan's going to continue to ease. The ECB's going to continue to ease, as Mario Draghi has said. The Fed is on a different course right now.

You're going to continue to see volatility returns in the market, and you're going to continue to see country dispersion. But that's why investors have to be diversified at the macro level so that you don’t overlook opportunities. Volatility brings opportunity.

ETF.com: And your thoughts on QE?

LaBella: Monetary policy the last five years has been flat—there hasn't been differentiation. Everyone was on an easing platform. There's been forward guidance. The Fed has certainly suppressed volatility. It's no coincidence that as soon as the Fed ended forward guidance and did QE, did the first rate hike in years, volatility came back. Now we’re going to see slow increases over time.

That's a very different place than where the ECB is, the Bank of Japan is and where many emerging markets are. They're going to continue to support and enhance stimulus, because they’re several years behind the Fed. They weren't as aggressive initially. And now they’re catching up. This is going to be a multiyear trend.

Related ETFs: Legg Mason US Diversified Core ETF (UDBI); Legg Mason Developed Ex-US Diversified Core ETF (DDBI); Legg Mason Emerging Markets Diversified Core ETF (EDBI); Legg Mason Low Volatility High Dividend ETF (LVHD)

Contact Cinthia Murphy at [email protected].