What’s Next for ETFs: The Evolution of Smart Beta and Active Strategies

What’s Next for ETFs: The Evolution of Smart Beta and Active Strategies

It wasn’t all that long ago when financial experts and regulators were asking the question “What is an ETF?”. How far the industry has come in such a short space of time. In May 2017, it was reported by ETFGI 1 that the global ETF/ETP industry with US$3.913 trillion in assets at the end of Q1 2017 was US$847 billion US dollars larger than the global hedge fund industry which had assets of US$3.066 trillion at the same period end. It is difficult to pick up a broadsheet newspaper today without seeing commentary on ETFs extolling the ingenuity and virtues of these investment tools.

The case for low cost passive investing

Warren Buffett famously bet $500,000 that hedge fund managers would have trouble outperforming a low cost S&P 500 index tracking fund over a ten year period between 1 January 2008 and the end of 2017. His primary rationale was that the higher fees charged by such active funds would outweigh the financial acumen of their managers. The silence from the hedge fund industry was almost deafening with only one manager willing to take the hedge fund side of the wager. As at the end of 2016, Buffett’s index investment, using Vanguard’s S&P 500 ETF, has had an average annual return of 7.1% while the hedge side of the bet (investing in five hedge fund of funds) has averaged an annual return of 2.2%2. The case for low cost passive investing would appear to be persuasive.

What’s next for ETFs?

So what’s next for ETFs? Continued success is the simple answer but that’s too easy. Passive investing is not without risks. Sure they are the most cost-effective mainstream investment products, which ultimately, is their biggest draw. This should be enough to see the long term horizon investor continue to invest regardless of market performance. That said, markets have been good in an era of quantitative easing. Traditional market cap weighted index products have thrived. But what happens when markets fall? Rapid and / or prolonged bear markets will see a return to a chorus of “I told you so” aimed at passive and ETF investors. Will they be right? Well, yes and no. It is clear that traditional cap market weighted indexing has its limitations, most notably that they are not nimble enough to protect capital in bear markets. What’s not clear is whether the mainstream market understands this point well.

Opportunities for smart beta and active ETFs

As with the original ETFs (which purely tracked indices based on market weighting), the US was the first to embrace smart beta (or strategic beta) and active ETFs. Before we discuss opportunities for these ETF types, we must firstly clearly distinguish them. Smart beta ETFs are passively managed products where the shape and the weighting of portfolio holdings differ from market-weighted ETFs. These differences result from the application of a prescribed factor or factors. By way of example, the index tracked by a smart beta fund could be to apply a heavier weighting to low volatility stocks, or low-priced stocks or higher quality stocks or a combination of such factors. In contrast, active ETFs are the same as other active funds except the fund is in an ETF wrapper. As such, the investment manager of such a product has full discretion on portfolio composition once it is within the scope of the fund’s investment objectives and regulatory framework.

The attraction of smart beta to investors is clear. It provides a low cost route to invest in a product with a defined objective which differs to just following the broader market – an advantageous feature for investors who consider themselves fully/over allocated to traditional market cap ETFs. These funds have clearly defined factors which can be back-tested against the market – an attractive feature for chartists. However, past performance is not a reliable indicator of future returns. “Black swan” events have occurred and will occur again. It is too soon in the life of smart beta products to determine whether they are living up to their name but it is clear that they have been massively embraced by markets. Globally, more than $500 billion is invested in smart beta ETFs and BlackRock estimates this will rise to $1 trillion by 2020, and $2.4 trillion by 2025 3. This is supported by FTSE Russell’s 2017 smart beta survey which reported utilisation of smart beta strategies by asset owners climbing to 46%, up from 36% last year4. The proliferation of smart beta ETFs in the US has actually resulted in there now being more US indices than US equities5.

In contrast, active ETFs would appear to be a more challenging proposition. Historically, the management fees of active funds are a lot higher than their passive counterparts (ETF or otherwise). The primary reason for these higher fees is that you are paying a premium for an investment manager and their supporting functions, including research, risk, etc., to pick stocks to outperform the market. As such, an investor is buying (hopefully!) the manager’s intellectual capital. This creates two issues. The first, as demonstrated in our earlier example, is that costs have a tangible impact on investor returns and ETF investors are by now accustomed to low fees on their passive holdings. Managers are going to have to find a pricing point which is attractive to ETF investors but which keeps the lights on. The second point relates to transparency. In a normal active fund, an investor only gets sight of the full portfolio of the underlying fund assets periodically and, normally, a period of time has elapsed before the information is published. Contrast this to ETFs which publish portfolio composition files on a daily basis. How can an investment manager in this scenario expect to be as effective - it’s the equivalent of starting a hand of poker by showing your opponents your cards. In the US, there are about 170 active ETFs that disclose their holdings, but they have failed to gain material traction making up approximately 1% of the US ETF market 6. Some ETF issuers have tried to tackle this problem by creating a timing lag to publication of a portfolio composition file but growth in this product space is likely to hinge on clarification regarding transparency requirements from global regulators.

As with most things in life, you can have too much of a good thing. There is a danger in investors becoming obsessed with low fees, investing solely in passive beta or smart beta products and forsaking alpha opportunities. Whilst Warren Buffett is extolling the virtues of passive, it is noteworthy that Berkshire Hathaway has massively outperformed the market since inception. There will always be a place for quality active fund management. The challenge for the ETF industry will be to work with investors – both primary and secondary, investment managers and regulators to continue developing efficient innovative investment solutions that keep all parties happy.

Robert Malone and Paul Heffernan, members of HSBC Securities Services ETF Innovation Team. 

1 ETFGI.COM Press Release 18 May 2017

2 Berkshire Hathaway 2016 Annual Shareholder Letter

3 Irish Times: Stock pickers face scrapheap as investors turn to algorithms, 18 April 2017

4 FTSERussell: 2017 Smart Beta Survey

5 Bloomberg News: There are now more indexes than stocks, 12 May 2017

6 Bloomberg News: Precidian moves closer to non transparent ETF with SEC filing

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