Will smart beta ETFs revolutionize the asset management industry?

Article

Will smart beta ETFs revolutionize the asset management industry?

Understanding smart beta ETFs and their impact on active and passive fund managers

PerformanceMagazine

To the point

  • Smart beta is a rules-based portfolio-building process that harnesses indexing and ETF efficiencies while beating the risk return of traditional market-cap-weighted indices.
  • Smart beta ETFs are thriving—their market share of the European ETF market has risen from 1 to 6% over the last 15 years.
  • By expanding into smart beta ETFs, passive managers can enrich their value proposition to institutional investors and generate additional revenue.
  • Active managers can either leverage smart beta processes, or consider certain practices to provide investors with a richer understanding of returns and risk level, particularly institutional ones.
 

Worth approximately EUR€25 trillion in Europe in 2020, the asset management industry is mainly split between active and passive management. While active management still dominates the industry’s landscape, passive management’s share gained 4 points between 2008 and 2019 to reach 15% of total assets under management (AuM)1. This market shift is even more pronounced in the United States, where the passive management market share exceeded 40% in 20192.

Over the past decade, a new category has emerged and started gaining market share. Smart beta exchange-traded funds (ETFs) are the industry’s fastest-growing ETF product, attracting new inflows.  Various players are moving into this market by designing and launching new products.

In this article, we compare the value proposition of smart beta ETFs with more traditional investments and explore their implications for the industry.

 

Active management is increasingly challenged by passive management due to performance, fees and volume growth gaps


Active and passive management rationale for investing

Investment companies employ professionals to actively manage their clients’ funds because they believe this approach will outperform the market. Active managers execute their trade decisions to generate alpha (and performance), rather than following an index. They leverage analyses, research and their own judgment and experience. They can control the scope and timing of the securities they own.

To generate alpha, active managers can leverage or combine multiple techniques, such as:

  • Stock picking: selecting securities according to the analysis of various criteria, such as growth rate, intrinsic value and favorable trends.
  • Market timing: increasing the fund’s exposure when the market is on an uptrend and reducing exposure when the trend is reversing.

The potential benefits of active management include:

  • Exploitation of market inefficiencies: active managers can exploit pricing anomalies created by emotional biases and information failures. This can be one of the reasons why European small-cap equity active funds had the highest success rates3 compared with other European funds across all 1-year to 10-year timeframes.
  • Risk management: excluding companies or industries driven by negative trends, using various hedging strategies such as short selling, derivatives, and market timing strategies.
  • Niche market advantages: leveraging unexploited corners of the market where flexibility and knowledge are more important than size, such as thematic funds, e.g., water funds composed of mid-cap values.
  • Better resource allocation: passive investing can encourage inefficient allocation of resources by deploying capital towards the largest firms, rather than those generating the best returns—e.g., active large-cap funds that have different allocations than index.

Active managers claim to be especially successful during periods of market stress, by adapting their exposure accordingly. Average returns for European equity outperformed their benchmark S&P 3504 (1.44% versus -2.79% 1-year returns5) during the 2020 COVID-19 stock market crash.

On the other side of the spectrum, passive management seeks to track the returns of a specific index (e.g., CAC40, DAX30) and generally follows a capitalization-weighted index. Passive managers believe in the efficiency of markets: the highest returns are achieved by buying securities that follow market valuations.
 

Limitations of active and passive management

Actively managed funds typically charge higher fees than passively managed ones6 (approximately 0.9% versus approximately 0.15%, respectively). This fee gap has tended to hinder the development of passive management, as distributors prefer to benefit from active management’s higher fees. The fee difference is becoming increasingly difficult to justify, as active funds have shown disparate results when compared to passive ones (cf. figure 1b). The overall increase of passive funds’ market shares in both the United States and the European Union is piling further pressure on the fees of active managers.

As active management funds are dynamic, with portfolio and market correlation constantly evolving, it is difficult to measure their beta (i.e., the coefficient of correlation to the market). This means it is challenging to assess their risk-adjusted performance versus their benchmarks, as investors are unsure whether performance is due to managers’ judgments or risk variations. The risk dimension can be an issue, particularly for institutional investors who want to understand and monitor their asset allocations versus risk.

Both active and passive management have demonstrated limitations when addressing investors’ needs. Active management funds do not always have clear indicators, generally come with high fees, and often fail to outperform their benchmarks. While passive funds that are weighted according to each security’s market capitalization increase their exposure to the most expensive stocks versus those with the highest returns. These limitations have paved the way for the development of smart beta funds.

 

Figure 1a: European AuM7 (EUR trillions)

Figure 1b: Active funds success rates8 (% of funds beating their index over X years)

Active management is increasingly challenged by passive management due to performance, fees and volume growth gaps


Active and passive management rationale for investing

Investment companies employ professionals to actively manage their clients’ funds because they believe this approach will outperform the market. Active managers execute their trade decisions to generate alpha (and performance), rather than following an index. They leverage analyses, research and their own judgment and experience. They can control the scope and timing of the securities they own.

To generate alpha, active managers can leverage or combine multiple techniques, such as:

  • Stock picking: selecting securities according to the analysis of various criteria, such as growth rate, intrinsic value and favorable trends.
  • Market timing: increasing the fund’s exposure when the market is on an uptrend and reducing exposure when the trend is reversing.

The potential benefits of active management include:

  • Exploitation of market inefficiencies: active managers can exploit pricing anomalies created by emotional biases and information failures. European small-cap equity active funds had the highest success rates3 compared with other European funds across all 1-year to 10-year timeframes.
  • Risk management: excluding companies or industries driven by negative trends, using various hedging strategies such as short selling, derivatives, and market timing strategies.
  • Niche market advantages: leveraging unexploited corners of the market where flexibility and knowledge are more important than size, such as thematic funds, e.g., water funds composed of mid-cap values.
  • Better resource allocation: passive investing can encourage inefficient allocation of resources by deploying capital towards the largest firms, rather than those generating the best returns—e.g., active large-cap funds that have different allocations than index.

Active managers claim to be especially successful during periods of market stress, by adapting their exposure accordingly. Average returns for European equity outperformed their benchmark S&P 3504 (1.44% versus -2.79% 1-year returns5) during the 2020 COVID-19 stock market crash.

On the other side of the spectrum, passive management seeks to track the returns of a specific index (e.g., CAC40, DAX30) and generally follows a capitalization-weighted index. Passive managers believe in the efficiency of markets: the highest returns are achieved by buying securities that follow market valuations.
 

Limitations of active and passive management

Actively managed funds typically charge higher fees than passively managed ones6 (approximately 0.9% versus approximately 0.15%, respectively). This fee gap has tended to hinder the development of passive management, as distributors prefer to benefit from active management’s higher fees. The fee difference is becoming increasingly difficult to justify, as active funds have shown disparate results when compared to passive ones (cf. figure 1b). The overall increase of passive funds’ market shares in both the United States and the European Union is piling further pressure on the fees of active managers.

As active management funds are dynamic, with portfolio and market correlation constantly evolving, it is difficult to measure their beta (i.e., the coefficient of correlation to the market). This means it is challenging to assess their risk-adjusted performance versus their benchmarks, as investors are unsure whether performance is due to managers’ judgments or risk variations. The risk dimension can be an issue, particularly for institutional investors who want to understand and monitor their asset allocations versus risk.

Both active and passive management have demonstrated limitations when addressing investors’ needs. Active management funds do not always have clear indicators, generally come with high fees, and often fail to outperform their benchmarks. While passive funds that are weighted according to each security’s market capitalization increase their exposure to the most expensive stocks versus those with the highest returns. These limitations have paved the way for the development of smart beta funds.

 

Smart beta leverages a systematic portfolio building process to benefit from indexing while beating the risk/return of traditional market-cap-weighted indices


What is smart beta?

Smart beta strategies are designed to add value by systematically selecting, weighting, and rebalancing portfolio securities based on market factors, without being bound by market capitalization of underlying securities.

Compared with passive ETFs, smart beta ETFs take a unique approach to index construction. Managers actively collaborate with index providers to build the indices against which their ETFs will be tracked.

By focusing on index construction, smart beta aims to overcome some of the weaknesses of traditional beta. These portfolios can leverage multiple alternative weighting factors to replicate the exposure of a traditional price or cap-weighted index while maximizing its return, or vice versa.

Many of these weighting factors are not new; asset managers are already using them to actively manage their portfolios to identify elements of intrinsic value and stock that may, rightly or wrongly, be over or underpriced. They can include:

  • Value: inexpensive stocks relative to fundamentals such as price-to-earnings tend to outperform.
  • Quality: financially healthy companies typically perform better over time.
  • Dividend: companies that pay dividends tend to be well-established, financially healthy companies.
  • Momentum: stocks with a strong recent performance tend to maintain higher returns.
  • Growth: small, high-growth companies tend to outperform their larger counterparts.
  • Minimal volatility: stable securities can outperform more volatile securities on a risk-adjusted basis.

 

But beyond the use of these factors to try to identify over or underpricing, at an aggregate level, a portfolio’s exposure to these factors is a relevant way to capture risk premia. The clarity of factor exposure and the benefit of indexing can mean smart beta combines the best of both worlds.

The popularity of smart beta ETFs or ETPs more broadly (including non und products like SPVs) has grown significantly in the past years.

  • In Europe, smart beta’s share of the total ETP market has increased from less than 1% in 2005 to approximately 6% in 2020. By the end of 2020, the number of ETPs reached 160 and the total AuM amounted to EUR63 billion.
  • iShares, managed by BlackRock, is leading the smart beta ETP market in Europe by far, with more than 47% market share.
  • Most major asset managers, including Lyxor, Amundi, UBS and Vanguard, are offering smart beta ETPs today. They are uniquely positioned as they have the broadest access to institutional investors, who are typically the most interested in smart beta.
  • Other medium-size or smaller players have also positioned themselves in the landscape, including CoreShares, Desjardins GAM and JPMorgan, and smaller actors are increasingly considering offering smart beta ETFs.

As for fees, smart beta ETPs position themselves between active and passive management, with average fees ranging from 0.2 to 0.5%. Fees are declining for active, passive and smart beta funds, while fee pressure continues to rise as the competitive landscape becomes more crowded. New smart beta entrants offering lower fees could have an edge on dominant players, challenging their current umbrella pricing setups.

Added value of smart beta funds

Smart beta ETFs aim to improve returns or minimize risk compared to their benchmarks. The way they measure risk is more explicit when compared to traditional active funds. This feature is particularly interesting for institutional investors, who need to measure their risk exposure and betas and grasp their resource allocation with greater accuracy.

Smart beta ETFs’ success rates compared with their benchmarks are positive as illustrated by academic research over the years, but they are also complex to evaluate, especially in the current environment.

Theoretically, smart beta ETFs should also be able to capitalize on the 2020 market crash to demonstrate their added value. Due to the current landscape’s broad spectrum of varying strategies, they performed heterogeneously in the first months of 2020. Five out of the 11 smart beta categories have outperformed Morningstar Category Indexes in terms of average returns (commodity, growth, momentum, quality, and risk-oriented) and six out of 11 categories boasted success rates for their ETFs greater than 50%. Also, there were significant differences even within the same category, particularly commodity, due to the diversity of ETPs available and the category’s high volatility during that period.

Smart beta strategies could significantly impact the asset management industry. Particularly active management, as many traditional active managers deliver part of their returns via static exposures to smart beta factors while charging active fees. Additionally, smart beta strategies suit institutional clients that require specific risk measurements. With these investor types owning more than two-thirds of the AuM in Europe, this could further boost their adoption rates in the coming years.

 

What does smart beta mean for different asset managers?


Passive managers: expand into smart beta

Well-constructed smart beta ETFs will progressively gain market share with institutional investors, as they provide a superior performance-to-risk ratio when benchmarked with passive funds (i.e., a similar performance with reduced risk, or enhanced performance with similar risk). They can also clearly display their indicators (alpha, beta, or R-squared). Passive managers that diversify their offering with smart beta ETFs could be onto a winning strategy.

  • Leading asset managers with the necessary infrastructure and access to institutional clients could leverage smart beta ETFs to generate additional revenues, as their fees are higher than passive ETFs (cf. figure 2).
  • Small-to-medium-sized asset managers can leverage smart beta to provide a differentiated value proposition with the multiplicity of risk factors. They can also position themselves on niche segments where they would not be penalized by the scale effect versus leading asset managers.

Asset managers will have to tackle various challenges, such as production (e.g., human resources, research and development capabilities, IT systems) and distribution. The latter is particularly important, as many investors lack knowledge of smart products. Marketing campaigns by asset managers can help increase awareness of smart beta products and their added value to both distributors and investors.

Active managers: act quickly and leverage certain smart beta practices

Smart Beta ETFs could substantially impact the value proposition and fee model of traditional active managers.

  • Many active funds are already struggling to outperform their passive benchmarks. This will become more challenging with the rise of smart beta ETFs, with their enhanced performance-to-risk ratio and competitive fees (cf. figure 2)
  • Smart beta ETFs have elevated the standard of communication between asset managers and investors. Active managers could leverage these practices to improve communication around performance, and provide a richer understanding and granularity of the level of risk.

Managers will need to investigate the relevance and implications regarding fees and product offerings before expanding into smart beta ETFs. They should pay a lot of attention on index construction when selecting index providers and could even move into the business of constructing indices.

Not only asset managers but also broader financial services players can get involved in the smart beta evolution, as illustrated by the sale of Scientific Beta by EDHEC Business School to the Singapore Exchange.

Figure 2: weighted average equity ETF fee9 (%)

References

1 European Asset Management Association, Nov. 2020

2 Federal Reserve Bank of Boston, The Shift from Active to Passive Investing: Risks to Financial Stability?, May 2020.

3 Success is measured by the capacity of an active fund to provide a higher performance versus its benchmark index.

4 Europe S&P 350.

5 SPIVA Europe Scorecard, 2020.

6 Factset.

7 European Asset Management Association, Nov. 2020.

Morningstar, 2020.

 

Conclusion

Smart beta ETPs are disrupting the activities of active fund managers—while they share some of the features of active fund management, they charge lower fees and are more explicit in the indicators they share with their clients.

Just as Vanguard revolutionized asset management by introducing low-cost investment solutions, smart beta ETFs could pave the way to a durable investment style that boasts both active and passive management features.

While their market share is still relatively small, they are growing fast and have reached more than a 20% share of the US ETF market, a hint towards their possible trajectory in Europe.

 

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