Investors like smart beta.
According to London-based ETFGI, an independent research and consulting firm that monitors ETF/ETP trends, U.S. smart beta funds attracted $69 billion for the 11 months ending November 2017. That was a 30.1 percent year-to-date increase, which ETFGI reported as the largest annual increase since 2009.
This active growth looks set to continue. For example, in November 2017, Vanguard announced that it had filed a registration statement for six new factor-based ETFs and one factor-based mutual fund. BlackRock’s iShares already offers over 100 smart beta funds and plans to offer more.
Slower Adoption Among U.S. DC Plans
Plan sponsors are showing interest in smart beta and factor investing. Among sponsors considering smart beta strategies, BlackRock’s 2017 DC Pulse Survey reported that:
- Eighty-six percent of plan sponsors saw smart beta as an alternative to traditional active management;
- Eighty-one percent believed it was appropriate to offer smart beta as part of a multi-asset class solution like a target-date fund; and
- Seventy-five percent agreed smart beta strategies could serve as replacements for traditional capitalization-weighted indexes.
The latest DC Pulse Survey results support previous results, says Anne Ackerley, head of BlackRock’s U.S./Canada defined contribution business. In her experience, plans’ smart beta DC implementations have been roughly equally split between offering the funds as standalone options and including them in target date funds. “The [most recent] survey shows that interest in factor investing is increasing among plan sponsors,” she says. “Last year, the survey showed that about 24 percent were using some form of smart beta and, this year, that’s up to 38 percent of the plans surveyed.”
Interest is growing, but it’s still “very early days” in smart beta’s evolution, says Nick Nefouse, CFA, managing director, head of DC investment and product strategy with BlackRock. He notes that indexing came to the forefront around 2000 to 2001 and took about 10 years to become a mainstream strategy among DC plans. Incorporation of smart beta will also take time, he believes. Although some plan consultants are comfortable with the underlying premise of smart beta and factor investing, others have spent less time with the research because many of the products are new.
The U.K. Experience
Alistair Byrne, head of European DC investment strategy with State Street Global Advisors in London, cites a similar experience in the U.K. market. Although DC-market adoption statistics are not readily available in the U.K., the trend is clear, Byrne says, “Essentially, we are seeing a number of plans look at their passive, market-cap weighted index fund strategies and think that they can improve the risk and return profile by adopting a smart beta strategy. That’s primarily the larger funds leading that trend.”
Byrne cites several UK-market characteristics influencing interest in smart beta. The first is that U.K. DC plans face a regulatory annual fee cap of 75 basis points which includes recordkeeping, investment management and other fees. Another factor is that active management is less prominent in U.K. plans, so a transition to smart beta is “less about trading down from active,” he explains. “It’s more about moving to a more sophisticated approach than cap-weight indexation.”
Enhancing the Glide Path
Smart beta’s ability to enhance the retirement plan glide path is another feature that might spur plan sponsors’ interest. Nefouse explains that the market’s thinking about the glide path is essentially the split between stocks and bonds. As participants approach and enter retirement, the simplest and most blunt method for adapting to changing risk tolerance is to add more fixed income.
Smart beta strategies can improve that approach and act like a second glide path within the target date plan because there are different factors with different risks within the equity and fixed income markets, says Nefouse. For example, traditional target date funds own the S&P 500 across the entire time horizon but smart beta can refine the equity allocation based on the participant’s age. BlackRock has taken this approach to the glide path in its Life Path Smart Beta target date funds.
“When you’re young you want to own higher-growth equities, things like value, size, momentum and quality,” Nefouse explains. “Now, we know when those are going to give you a higher amount of return in the portfolio; however, when you age, what we can do is we can actually swap out some of those higher-returning factors and we can add in things like minimum volatility while maintaining quality. So, the mix of equities will change.”
State Street has adopted a similar approach with its Timewise Target Retirement Funds. Byrne says that the firm introduced the smart beta element to the funds last year and in November increased the smart beta allocation to 25 percent of the portfolios. Younger participants receive greater exposure to higher-growth factors while older participants’ accounts have a greater focus on high quality and low volatility, essentially “using the factor exposures as part of the de-risking glide path,” says Byrne.