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“Smart Beta” Edging Into the Mainstream

Adoption of the factor-tilted funds continues for advisors, with almost one-quarter using them to replace a plain vanilla option.

It’s no surprise that exchange traded fund (ETF) investors are looking beyond plain vanilla offerings that mimic major U.S. stock indices. What may be surprising is the rapid adoption of “smart beta” ETFs at a pace that doesn’t appear to be slowing, according to a new study from Brown Brothers Harriman (BBH) and ETF.com.

“There is a deepening of ETF usage and further adoption among existing users,” says Ben Johnson, global director of ETF research at Morningstar. “Investors are using ETFs in greater quantity and in different ways, with different types of ETFs.”

Johnson said both fixed income and smart beta funds are the primary benefactors of the expansion. “Advisors are looking to something that might have more upside than just the market and with a lower price tag than an active manager.”

Smart beta funds, more usefully called “strategic beta,” are constructed using different weightings of the indices’ underlying components, or selecting them based on factors like size, value and momentum.  

The BBH/ETF.com survey of 175 U.S. financial advisors and institutional investors found that 97 percent of respondents plan to maintain or increase their allocations to these kinds of funds in 2017. Almost 60 percent of advisors bought a smart beta ETF in 2016, up from 49 percent just two years ago. Twenty-three percent of those advisors replaced a plain vanilla fund with a smart beta option, while 30 percent used them to replace either a satellite alpha-seeking position or an actively managed fund.

“Smart beta continues to be an attractive option for investors who want to own products in the middle of the traditional passive and active spectrum,” Shawn McNinch, managing director of U.S. ETF services for BBH, writes in the report. “With more smart-beta options available, investors have more choices to meet their needs, whether that’s the potential for improved diversification, lower costs, better risk-adjusted returns or all of the above.”

“Not everyone wants to buy three Vanguard index funds and call it a day, even though that may be the best thing for them,” says Eric Balchunas, ETF analyst for Bloomberg Intelligence. It’s human nature to want to best the indices, he says. “Smart beta offers the opportunity to outperform without high fees, and you almost never have capital gains.”

Smart beta ETFs also work well for advisors who want to provide added value to their clients, Balchunas says. “A lot of clients and their advisors are dismayed with active managers,” who, historically and on average, underperform their passive colleagues.

Of course, the odds of reaping the benefits of the strategies increase over the long term. “These factor-based bets will have their own performance cycles,” Johnson says. “At times they will outperform capitalization-weighted indices and their peers, and at times they will underperform, just like good active managers. The only way to enjoy long-term outperformance is to stick with it through thick and thin, which can be very difficult to do,” Johnson says.

When asked which smart beta strategy they were considering for equity exposure, the most popular choice (44 percent of advisors) in the BBH/ETF.com survey said minimum volatility. “Investors are growing wary about what’s always an uncertain environment in the market,” Johnson says, mentioning the tumult surrounding Britain’s vote to exit the European Union and the U.S. presidential election as examples. “People want to maintain equity exposure but take less risk.”

After soaring in the first seven months of 2016, these minimum volatility funds erased some of the gains in the final five months. “Smart beta gets a lot of performance-chasing money, and that creates risk,” Balchunas says.

Not everyone has a favorable view toward smart beta ETFs. “Ninety percent or more of them are nothing more than garbage,” says Larry Swedroe, director of research for Buckingham Strategic Wealth in St. Louis. “They’re designed to make you think they’re smart, but it just gives you exposure to different beta. It’s marketing.”

Strategic beta funds still only account for about 9 percent, or $22 billion, of the money flow into ETFs last year, leaving them with 19 percent of the industry’s assets, according to Balchunas.

Meanwhile, when asked what sectors could use more ETFs, 31 percent of respondents to the survey named international fixed income, and 23 percent chose commodities. Those areas showed the biggest growth from 2015, though their totals continued to trail alternatives at 40 percent.

International fixed income represents a logical step in the development of ETFs, many experts agree. “First you had U.S. equity, then international equity, then U.S. fixed income, then internal fixed income,” Balchunas says. “There are only a few global bond ETFs now. It’s where other categories were 10 years ago.”

Analysts are more skeptical about commodities. “Commodities have been absolutely crushed over the past few years,” Johnson notes. That may make investors more open to new investment offerings in the space. “But is there any magic in an asset class that has looked anything but magical in the last number of years?” he asks. “To the extent that commodities offer diversification, I can see why the interest is there. But most people are well served by what’s already on the menu.” 

Balchunas sees problems with commodity funds that invest in futures because of the complications of rolling over futures contracts. That can lead to contango, where the futures contracts are more expensive than the spot price, or backwardation, where the futures are cheaper than the spot price. The costs of rolling over futures can lower returns by more than 30 percentage points a year, Balchunas says. “I have yet to see a product in the futures market that’s good for long-term investors.”

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