How Smart Beta ETFs are Changing

Constant innovation is the name of the game in smart beta benchmark development, not to mention a way for ETF providers to differentiate themselves 

Jose Garcia-Zarate 27 October, 2017 | 12:20PM

Strategic beta – commonly known as “smart beta” – ETFs are growing in popularity in Europe. They already account for 8% of the assets invested in ETFs, and the growth outlook remains positive, with an average of 10%-15% of monthly net inflows into ETFs in Europe directed to this type of products. Thus, it should come as no surprise that ETF providers consider smart beta as one of their key business areas for the coming years.

Dividend strategies remain particularly popular

Constant innovation is the name of the game in smart beta benchmark development, not to mention a way for ETF providers to differentiate themselves from each other and capture market share in what is becoming a very dynamic marketplace.

This means that a substantial share of the product development budget, both of index and ETF providers, is being devoted to researching and bringing to the marketplace a raft of “ever-smarter” strategies.

It must be said that in absolute terms, the bulk of assets in smart beta ETFs in Europe is still located in products providing exposure to single factors. For example, ETFs tracking dividend-screened/weighted equity strategies remain particularly popular, as investors continue to favour ways of improving income streams in the current ultralow interest rate environment.

However, when it comes to product development, the European ETF market is already in a phase where new single factor funds are simply filling in missing geographical spots.

The Next Step: Multi-strategy Funds

Multi-factor strategies are the natural evolution in the field of smart beta, and the place where product research and innovation currently thrives. Multi-factor smart beta ETFs are marketed as investment solutions that address the most obvious shortcoming of single factor equity exposures, namely their cyclicality. Indeed, when it comes to investing in equity factors, the adage of “don’t put all eggs in a single basket” also applies.

The question for index and ETF providers is how to combine factors in the most efficient way to improve the overall risk/return profile of the multi-factor fund while minimising turnover costs.

The most straightforward way of combining any range of factors, and certainly the simplest for investors to understand, is to follow an equal-weighting approach. Some of the early multi-factor smart beta ETFs launched in Europe followed this approach.

However, we are now seeing further evolution in product development, with many of the new products coming to the market built following a “core-satellite” framework, where one of factor acts as the core building bloc and the rest – whether just one or a combination of several – address the potential downsides of its cyclical nature.

Quality-dividend indices and the ETFs that track them are a good example. These products screen dividend-paying companies for “quality”; favouring the more profitable and less indebted with a view to delivering a less volatile income stream over the long-term.

Other products use low volatility as its “core” factor exposure and complement it with quality, value or momentum.

Some may argue that rather than multi-factor, this really is “single factor 2.0”, as the key focus of the product development process and subsequent marketing efforts is on the core factor of the structure.

Irrespective, it is fair to expect more products of this type entering the market. After all, multi-factor ETFs can be churned in many different combinations. This will make the task of benchmark and ETF selection ever more complex for investors.

A version of this article appeared in Investment Adviser Magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Jose Garcia-Zarate

Jose Garcia-Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe

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