Cerulli has published the March 2019 issue of The Cerulli Edge—U.S. Asset and Wealth Management Edition, which among other topics explores the benefits and drawbacks associated with strategic beta investing.
At the core, strategic beta or “smart beta” strategies aim to achieve enhanced, risk-adjusted returns by tracking an index based on specific rules or preferences. As opposed to conventional market-cap-weighted passive allocations, these funds weigh securities based on specific factors such as performance, dividends, value, volatility and more. In this sense, smart beta seeks to outperform passive indices by taking a more nuanced, “active” investing approach.
Cerulli says strategic beta products offer advisers the opportunity to fine-tune investment exposures.
“However, they require increasing intellectual capital to select amid an abundance of options,” says Daniil Shapiro, associate director at Cerulli. “A key challenge for strategic beta strategies is the difficulty that advisers face in interpreting them.”
Cerulli’s report makes the case that the increasing expertise required to understand smart beta products, and that key discrepancies in how they are positioned hinder product use.
“Cerulli’s adviser survey indicates that only 21% of advisers report using strategic beta products—a smaller portion than would be expected given the wide availability and product development focus,” Shapiro says. “It is likely that the ambiguity about factors and what they are intended to accomplish is challenging strategic beta adoption.”
About a year ago, FTSE Russell found in its own survey that advisers were only beginning to embrace smart beta strategies. At that point, 47% of advisers in the U.S. said they did not know enough about the tactic to see it as a viable opportunity. While 79% percent of U.S. advisers said they were aware of smart beta, but just 36% said they were very familiar.
Cerulli’s new reporting suggests the same fundamental challenges to smart beta adoption remain firmly entrenched.
“In examining how issuers position strategic beta exchange-traded funds, Cerulli finds that 68% of issuers often present the products as providing specific factor exposures, while 50% state that they position the ETFs as generating alpha,” Shapiro says. “Advisers, meanwhile, report using strategic beta products based on their desire for key outcomes, particularly downside risk protection and reducing portfolio volatility.”
Additional context for the new Cerulli report can be found in a recent interview PLANADVISER conducted with Mike Hunstad, head of quantitative strategies for Northern Trust Asset Management. Hunstad took a deep dive into the complicated subject of factor-based investing within institutional portfolios.
According to Hunstad, many types of institutional investors, including defined contribution (DC) and defined benefit (DB) retirement plans, first started to embrace factor-focused portfolios and smart-beta strategies as a means of achieving excess returns. With the latest bouts of market volatility there has been something of a rush into the low-volatility factor, but other factors are also receiving increased client attention. Many institutions have found real success with factor investing and smart-beta, Hunstad suggested, but there are some emerging challenges that investors must be made aware of. In particular, he warns that institutions may be trying to implement too many factors at the same time without considering the complex interplay between sources of portfolio risk and returns. As a result, many investors have so far “diluted” the effectiveness of smart beta.
Cerulli’s report suggests advisers have a role to play in resolving such issues, and that advisers have a lot to learn before they can make the most of smart beta.
“Almost three-quarters (71%) of advisers report that not knowing whether the strategies are meant to produce alpha or outperform is a significant or moderate reason for not using them, while another 67% state the same about lack of familiarity with the strategies,” Cerulli’s report says. “Strategic beta ETFs, as indexed investments, are not alpha-generating, while using such products in concert may be alpha-generating but requires a highly skilled approach only available to the most proficient users.”
Shapiro says increased innovation across strategic beta products, and particularly with respect to multifactor products, has led to a broad increase in complexity, which has, in turn, challenged adviser adoption.
“With performance varying widely between products, advisers will be hard-pressed to make a defensible investment decision,” Shapiro adds.
In its report, Cerulli recommends that advisers use strategic beta products to fine-tune investments in line with their clients’ goals. As an example, the report points to “using a size factor product for a client with a long-term horizon looking to take risk away from mega-cap products,” or using a low-volatility approach for a client with a lower risk tolerance.
“In addition, we suggest that issuers similarly focus on product education from an outcome perspective versus positioning individual products based on their potential to outperform,” Shapiro recommends.
Cerulli’s report suggests a key consideration for the creation, operation and understanding of any strategic beta product is the weighting scheme that it uses to provide exposure.
“While an ETF product will use its specific factor as a selection tool, ETFs that select securities based on a factor and then provide market capitalization weighting based on the sizes of the market caps of the companies selected typically offer tilts,” the report explains. “Such products continue to heavily resemble the underlying index, while those that also use the exposure to the factor itself (as opposed to market capitalization) as a basis for the weighting will create more pure factor exposure.”
Also important to note, according to the report, is that factors are likely to overlap.
“Low volatility, quality and dividend factor products, for example, typically hold at least some of the same securities,” the report says. “Arguably, what one methodology defines as a factor can be captured via a different factor from another provider. Vanguard’s Liquidity factor exposure and MSCI’s Size factor exposure, for example, both invest in companies with market capitalizations smaller than that of the average MSCI USA holding.”
Cerulli’s report goes on to suggest “an interesting gap” in strategic beta has occurred on the fixed-income product side of the market.
“Currently, only 46 ETFs are classified as fixed-income strategic beta, a low amount given the natural applicability of strategic beta to fixed income. Market-cap weighting is less applicable because it results in counterintuitively making the largest investments in the most levered companies, and the overall large size of the ETF universe,” Cerulli explains. “Fixed-income strategic beta products may appear an attractive opportunity for issuers, but we caution that the availability of active fixed-income ETFs may serve as a counter-balance.”
These findings are from the March 2019 issue of The Cerulli Edge—U.S. Asset and Wealth Management Edition. Information about obtaining Cerulli Associates research is available here.