Smart Beta ETFs Grow In Popularity In 2015

As we approach the end of 2015 we have seen investment into smart beta exchange traded funds increase rapidly over the year.

Independent research house ETFGI reported record inflows of $53.7 billion into smart beta equity ETFs from January to October 2015.

Deborah Fuhr, managing partner at ETFGI, explained that the growth is due to many investors finding it difficult to find active mutual funds that can consistently deliver alpha, therefore they are looking for indexes that help them deliver "systematic sources of alpha".

Fuhr warned, however, that smart beta may not always deliver alpha, and investors have to be careful as there are times when certain risk factors can underperform for multiple years.

Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ, said in a research note that he is also seeing significant growth in the smart beta space. He added that as investors increasingly consider fundamentally weighted smart-beta ETFs, it is important to understand and closely monitor how the exposure these offerings provide can and does change over time.

Investors Still Wary

Adam Laird, passive investment manager at Hargreaves Lansdown said he was very sceptical about a lot of these products for a long time.

"Many [smart beta investments that were released] have short track records and often seem to simplify complex products," he said. "We didn't feel there was justification [for that simplicity] in some cases with the products that were released."

He explained that many providers are conscious of upcoming interest rate changes which would impact ETFs, and have deliberately launched new products which are designed to mitigate the risk of rising interest rates.

"I think that [investment trend] will continue but also these [products] are being used by individual investors, and less sophisticated investors, and that is a big area of growth," he said.

Smart beta products have existed over 12 years. However, Fuhr said investors can expect to see more product development in the near future.

"Many pension funds and institutional funds are interested in single and multi-factor ETFs and increasingly retail [investors have] always been interested in income," she said.

Certain Funds Gaining Momentum

ETFGI reported the top five smart beta funds in Europe for the end of October 2015 were the SPDR S&P US Dividend Aristocrats UCITS ETF (SPYD), the iShares MSCI World Minimum Volatility UCITS ETF (MVOL), the iShares STOXX Global Select Dividend 100 UCITS ETF (SDGPEX), the HSBC ESI Worldwide Equity UCITS ETF (HEWA) and the iShares EURO Dividend UCITS ETF (IDVY). These five funds stand at $5.7 billion as of the end of October, illustrating that the list of most popular smart beta ETFs is top heavy in a select few, and that investors are focused on seeking income and controlling volatility.

Robert Nestor, managing director of BlackRock's iShares business, said the most popular smart beta iShares ETFs for 2015 have been dividend and low volatility. He explained that iShares has roughly $9 billion invested globally in low volatility strategies.

Another major player worth highlighting in the European market is WisdomTree Europe.

Rosenbluth said: "WisdomTree's ETFs are focused on the cash dividends paid out by their constituents. As such, when a non-constituent raises its dividend higher than others in the index on an annual basis, the stock may be added to the index."

Like Rosenbluth, Hargreaves Lansdown's Adam Laird pointed to the WisdomTree Europe smart beta ETFs.

"One of the groups we are looking at is WisdomTree, a big U.S. group which is new to the UK. Their products are income-focused and they have a good track record," he said.

Multi-Factor Taking Off

Fuhr said that a recent innovation in the ETF space has been multi-factor funds, that package up a number of risk factors, like growth, value, dividend, quality etc, into one fund.

"We have seen a movement into multi-factor calls," she said. "For many investors, when they move beyond dividend and income, it is harder for them to decide which individual factor to invest in and many are moving into multi-factor."

Nestor said he believes that European investors will see continuous innovation in the multi-factor space.

"In 2015 we have seen an explosion in smart beta multi-factor funds," he said, pointing to iShares' FactorSelect ETFs, and new launches from asset managers like Goldman Sachs in the U.S. and Lombard Odier in Europe.

Are Annual Fees Coming Down?

Over time the costs for smart beta ETFs have halved every year in the U.S., according to a paper by investment management firm AllianceBernstein, with a multivariate long-only equity smart beta fund in the U.S. priced at around 9 basis points.

Laird observed that European smart beta ETFs still have a long way to go before being comparable with the U.S.-style low costs.

Despite the increase in new launches of smart beta ETFs in Europe, Laird said he had not seen prices come down, rather, issuers maintain higher charges on their old products and only apply lower charges to the more visible, new launches.

"This is a clever trick by ETF issuers," he said.

"My message is that you keep reviewing the charges," Laird added.

According to ETFGI research, the average asset-weighted total expense ratio for smart beta equity ETFs in Europe at the end of October is 38.5 basis points, while market cap ETFs were lower at 31.8 basis points.