Although money managers are rapidly increasing their allocations to “smart beta” exchange-traded funds (ETFs), they may not be fully aware of the complexities of some of these products, according to ETF experts who spoke at the 2015 Exchange Traded Forum in Toronto on Tuesday.
Smart beta — also known as strategic beta, intelligent indexing and factor-based ETFs — is a term that covers a huge array of strategies. However, what they all have in common is that they add a twist to the traditional, basic vanilla, index-based ETF strategy of weighting securities based on market capitalization.
In fact, it is in the area of smart beta ETFs that most of the product innovation is happening in the ETF landscape, with the waterfront already well covered with low-cost, basic index-based ETFs.
“There is a growing allocation to smart beta strategies, as well as movement toward combining multiple factors and strategies,” said Rohit Mehta, senior vice president with Toronto-based ETF provider First Asset Investment Management Inc. during one of the panel discussions.
Specifically, Mehta cited a survey conducted in January and February by FTSE Russell, a division of U.S.-based Frank Russell Co., that confirms the surge in smart beta ETFs and the mixing and matching of strategies.
The survey of a broad cross section of institutional equity managers showed that of those using smart beta ETFs, 76% had allocated more than 5% of their portfolios to smart beta products, up strongly from 60% who allocated more than 5% in 2014. The survey also found more than 55% of equity managers are allocating 10% or more of their assets to smart beta.
Another important difference between this year and 2014 is the increase in the percentage of institutional managers who are combining multiple smart beta strategies in their portfolios. In 2014, 59% of equity managers surveyed were using more than one strategy; in 2015 this rose to 71%. Furthermore, 22% of equity managers are using four or more strategies.
Although smart beta strategies have given advisors and their clients more choice and greater flexibility in the construction of portfolios, they have increased the complexity of ETFs.
In particular, ETFs began life as product that offered ordinary investors broad market exposure and easy and liquidity at “institutional prices,” said Peter Haynes, managing director, index products, with Toronto-based TD Securities Inc. at the conference. However, ETFs are now evolving to include sector-based or other strategies that may have an entirely different mandate than matching the market benchmark. Consequently, these products come with a different set of risk factors that investors don’t fully understand.
“We are getting away from the original promise of democratizing investing with lower costs,” Haynes said.
In turn, ETFs should have a “complexity rating” as they evolve to include components of active management, such as leverage, the use of covered calls, and other strategies designed to beat rather than match the market averages, or increase income or reduce volatility, suggested Stephen Elgee, chief investment officer with Toronto-based alternative investment manager Periscope Capital Inc.
“The danger is that [investment advisors] and clients may get caught up in products where the outcome won’t match what they expected at the beginning,” Elgee said.
In response to a moderator’s question during a panel discussion on the history of ETFs, Haynes said the one headline he doesn’t want to read in the future would be one that exposes a conflict of interest related to trading in active ETFs.
Specifically, information leakage related to changes in the composition of actively managed ETF portfolios and insider trading on this information could be problematic, he said.