Smart Beta ETFs & The Active Manager

[This article appears in our May 2016 issue of ETF Report.]

Janus Capital Group, one of the world’s best-known active management firms, stepped into the ETF space with a splash when it acquired VelocityShares more than a year ago. It recently moved beyond the legacy products from that purchase with the launch of two “smart growth” ETFs. Like many other active mutual fund managers, it rolled out smart-beta ETFs—the Janus Small Cap Growth Alpha (JSML) and the Janus Small/Mid Cap Growth Alpha (JSMD)—but its Head of Exchange Traded Products Nick Cherney says they won’t be a part of a traditional ETF family.

Can you give a big-picture overview of what Janus’ plans are in the ETF space?

The business strategy is to build out our offerings in three categories. The first one is tactical trading products, which really is our legacy VelocityShares business that’s been growing and is successful, and we’ll continue to build on that business.

And then on the Janus brand, we’re working on two categories of products. One is actively managed ETFs, which we obviously don’t have today, but we view that, where it makes sense in an ETF wrapper, we’ll be trying to bring clients actively managed products.

The last is what we call “enhanced beta.” The term “smart beta” has been retroactively applied to a wide range of products, and it means a lot of different things to a lot of different people. We’ve intentionally decided to call our products enhanced beta. And what that really means to us is that we’re focused on trying to develop ETFs that can help clients beat market-cap-weighted benchmarks. So I think the enhanced-beta category for us is one where we’re going to put a fair amount of effort into, and JSML and JSMD are the first new products that we launched in that category.

They're definitely a different take on the smart-beta concept. Can you talk about what the impetus was behind that methodology?

I think the reason they're different is because they're coming from a totally different perspective. A lot of what you see happening in smart beta is people trying to start from a market-cap-weighted benchmark and make some sort of tweak to it to make a modest improvement on that. Our approach was really the opposite; we have a 45-year franchise of fundamental, bottom-up stock picking, with teams of CFAs doing really traditional analysis, rooted very, very heavily in fundamental, single-company analysis. That's where Janus has made its bones.

The small- and midcap space is an area where we thought there was an opportunity to try to build a systematic process that was driven by an informed fundamental active process. And so really, these are trying to take much of the active process that we go through in Venture and Triton, which are the two actively managed small- and midcap Janus funds that have been very successful, with Venture going back over 30 years. They're five-star Morningstar funds and closed to new investors. We asked if there is some portion of that process that we can replicate in a more systematic way, and therefore offer it in an ETF, with the lower costs and the tax efficiency.

We sat down with that team and asked them, “What is it you look for?” There's a team of 15 analysts that’s out there interviewing CEOs and doing a lot of subjective analysis that we can't replicate. But we’re dealing with the universe of 2,000 or 2,500 stocks. And so there has to be some common themes among these companies, the things that they're looking for, from a fundamental perspective, that they think are going to drive long-term value in small-caps.

That really boils down to avoiding bad companies in a lot of ways. The Russell 2000 has lots and lots of companies that are not well established and maybe aren’t going to make it. It’s not like large-cap, where, by the time you're in the S&P 500, you're a well-established company, and by and large, a well-run company. There’s a massive variation in terms of the quality of companies that exist in the small-cap space.

And so we said, “That makes sense, but what does that mean specifically?” Our job was to spend a lot of time with our fundamental team and try to hone in and quantify what it is they're looking for. And that ended up in these products, which focus on trying to achieve what we’re calling “smart growth” or “durable growth.” That’s companies that we believe are going to be able to sustain their business model through varying economic conditions, and therefore, will perform better, we hope, in market downturns, which tend to have a really significant negative impact on small-cap companies.

So you're taking the active strategies that have brought Janus so much success and crystallizing them into index-based strategies?

From a technical perspective, they're index-based strategies, because we write down rules and fully disclose. What we’re trying to do, though, is really capture the active process, that stock-picking process. We’re going through 2,000 stocks and looking at the fundamentals of the companies themselves.

For example, something that’s very unique about these products that doesn’t exist, by and large, in the sort of traditional smart-beta space, is that we don’t look at the price at all. So there's no PE, there's no price to book. Almost of all of the smart-beta products that are out there are still rooted in the idea that market-cap weighting has an ability to outperform.

If you look at a lot of what happens in this smart-beta space, it’s just trying to use some metric other than market cap to get at the fair value of the company. And that's not what we’re doing here. What we’re doing is looking purely at the underlying fundamentals, ignoring the stock price, ignoring the market capitalization—just asking, “Are they growing their revenues? How are they growing their revenues? Are they doing it consistently?” Then the same thing: “How are they turning that into profitability? Are they doing it consistently? And do we believe they're going to be able to continue to be profitable into the future?” And then the same kind of view on capital efficiency.

So it’s traditional bottom-up fundamental stock analysis that looks fairly distinct, I think, from what goes on in a typical smart-beta ETF. We’ve just quantified it.

Are there going to be more funds that use the “smart growth” investment methodology?

Janus obviously is broadly diversified, though the history is definitely in concentrated growth equities. But we have our growth fundamental equity business; we have Perkins, which is a value manager based in Chicago. We have Intech, which is mathematical investing and focused on institutional investors based in Florida and Princeton. We have our fundamental fixed-income team. We now have the global macro team with Bill Gross. We also have Myron Scholes here, running asset allocation strategies that are highly quantitative. So there's a wide range of products that are out there, and a wide range of areas where I think we’ll be interested in bringing out ETFs.

The specific application of the smart growth is one that’s very much tailored, explicitly, to small-cap U.S. equities. So we’re not saying this is a solution that is one-size-fits-all. This is a very, very specific philosophy that we’ve used for many, many years in the small-cap arena and that works in that space.

It’s certainly possible that we’ll roll out enhanced-beta products in other asset classes, or in other market caps or other regions. But again, we’d root those in the specifics of that situation. We’re not going to try to take a one-size-fits-all approach.

I’m guessing you’re not interested in launching just plain-vanilla market-cap-weighted ETFs.

The overarching principle in our product strategy—whether it’s our tactical products, our enhanced-beta products or active products—is that they’re products that advisors who are trying to do better than market-cap weighting would be interested in using, whether that’s because it’s an actively managed product where we think we can beat the benchmark; whether it’s our hedged equity products, where we think that the addition of a sophisticated volatility hedge can give you better returns over time, compared to a simple index-based product; or whether it’s access products like thematic ETFs, where the advisor itself is trying to generate that alpha. But that’s really the core of it.

The people who want to use plain-vanilla market-cap-weighted ETFs have plenty of places to go. We don’t have any particular expertise in that arena. And it’s definitely not where we’re focused.