Inside ETFs: Take time to understand the complexity of smart beta ETFs

In 2015, smart beta ETFs accounted for more than half of the new ETF launches and almost a third of total inflows into the US$2-trillion ETF market. “There is real money flowing into these strategies,” Bundy said.

Smart beta ETFs offer features that many clients and advisors want, including the potential for protection in down markets, controlled volatility and market-beating returns. Some are tilted toward value or growth investment strategies, which may beat the market in certain conditions.

“At the beginning, when smart beta was first introduced, it fell into the category of voodoo data mining, but it has evolved to the indexation of a quantitative approach to investing,” said Jason Hsu, co-founder and vice chairman of Newport Beach, Calif.-based Research Affiliates LLC, during the panel discussion. “You’re taking a systematic method of achieving a return and putting it in an ETF chassis — and at the same time offering transparency and low cost.”

The attraction of smart beta is based on the idea that markets can be inefficient, Hsu said. It is an attempt to beat the broad market indices, in which the components are based simply on the market capitalization of the underlying securities. However, he also reminded conference attendees that smart beta strategies also have the potential to lag the market.

In fact, Bill McNabb, chairman and CEO of Malvern, Penn-based Vanguard Group Inc., said later in his keynote speech that it’s important for investors to remember they are “making a bet” when investing in smart beta ETFs.

“We think of smart beta as active management implemented in a highly innovative, low-cost, diversified way,” he said. “It can make sense in some cases, but you need to be clear you’re making an active bet.”

FTSE Russell’s research also shows the most popular smart beta ETFs are those that are tied to specialized indices based on fundamental securities selection factors such as book value, dividend payment, earnings growth and cash flow.

Advisors tend to start with fundamental strategies, and branch out from there, Bundy said. Smart beta ETFs offering-low volatility strategies have become more popular during the past year or so as markets have shown some nerve-wracking downside moves.

“If you can identify ETFs with low downside capture, you can add value to a portfolio,” said Anthony Davidow, vice president with the San Francisco-based Schwab Centre for Financial Research, during the panel discussion on fundamental indexing.

However, Davidow cautioned that the term “smart beta” is a wrapper that encompasses a broad array of strategies with varying merits.

“There are a lot of differences in the various ETFs when you peel back the onion,” he said. “You need to understand how the ETFs are constructed, and that will give you a better sense of which ones might outperform in which types of markets. As the strategies in the smart beta space become more active, the necessary due diligence becomes more of a burden.”

In a later panel on smart beta, Simeon Hyman, head of investment strategy with ProShares Trust of Bethesday, Md., told conference attendees that it’s necessary for advisors to explain to clients why deviating from a traditional ETF based on a broad market index will add value.

“It’s a new conversation with the client, and it can be a trickier conversation then why you picked a certain manager of mutual fund or a certain index-based ETF,” he said. “Advisors need to think about how information can be translated into plain English. But if you can communicate the value to clients, assets can be made ‘stickier’ and clients are more likely to achieve the benefits.”