The rise of strategic beta ETFs

Morningstar's global director of ETF research, Ben Johnson, outlines Morningstar's research in the field of non-traditional index ETFs.

Christopher Davis 11 March, 2015 | 5:00PM Ben Johnson, CFA

 

 

Christopher Davis: Hi, I'm Christopher Davis with Morningstar.ca. ETFs have gained increasing traction in Canada in recent years. Most of the 80 billion in ETFs in Canada are in traditional ETFs. They track indexes like the TSX and the S&P 500, but the fastest growing area of the fast-growing area is so-called smart beta, or as we call it, strategic beta. These are strategies that make some sort of bet relative to the overall markets. Assets in these strategies grew by 28% last year and now make up 11% of the total Canadian market. Here to discuss the rise of strategic beta ETFs is Morningstar's Director of Global ETF Research, Ben Johnson.

Thanks for joining us, Ben.

Ben Johnson: Glad, to be here. Thanks, Chris.

Davis: So if you listen to the ETF marketing people, they will make smart beta, strategic beta sound like the newest, greatest, latest innovation. But something you argue is that this isn't really anything new, the ideas behind strategic beta at least have been around for decades.

Johnson: Well, that's absolutely the case. When we came to the task of naming this category the first thing we did was kick "smart" to the curb, because not all of these strategies are smart. And even the smart ones aren't going to necessarily look or feel smart to investors across a whole market cycle. They are each going to have their own individual unique cycles of out or underperformance relative to a broad market-capitalization-weighted benchmark, and that's very important to understand.

Also important to understand, which you alluded to before, is that this is not a new phenomenon. This is really a phenomenon that can be characterized sort of as old wine in new bottles. So if you think of the different risk factors, the different premia that these strategies are looking to repackage and to exploit, there are things like value, things like momentum, things that have been documented in academic research, things that have been exploited by active managers, repackaged into factor bundles in a variety of different ways for decades now.

So this is not new wine, it's old wine, but the new bottle is what's new here. So the new bottle in this context is the ETF. The ETF at the end of the day is just a vessel to deliver an investment strategy. So to the extent that the ETF vessel is more transparent, more liquid, lower cost, relative to other packaging, that's really what's driving the newness of this and that's what's driving the excitement around the strategic beta subset of ETFs.

Davis: But you can't paint strategic beta with one brush, right? It's really a diverse group. Can you talk about how Morningstar divides these sorts of strategies?

Johnson: So that's absolutely the case. We talk about this in very broad terms. We paint with broad brush strokes, but underneath the hood what you see is this is a very diverse category of strategies. So we've developed our own taxonomy, our own series of attribute tags within our database that help investors isolate like strategies and make apples-to-apples comparisons between different funds that are taking similar approaches to offering a specific strategy or a specific type of exposure. So, at a very high level we talk about strategic beta.

If we go one level further down what we see is that they fit into broad buckets of return-oriented strategies, risk-oriented strategies and then other strategies. So, return-oriented strategies look to alter the return profile relative to its standard benchmarks. So they look to either improve returns or isolate a specific source of return, say dividend income.

Risk-oriented strategies look to alter the risk profile of a standard market-cap-weighted exposure, either by ratcheting it down such as in a low-volatility strategy or potentially ratcheting it up as in the case of a high-beta strategy.

And then the other bucket captures non-equity asset classes chiefly, so non-traditional fixed income benchmarks, non-traditional commodity benchmarks and the exchange-traded products that track those benchmarks.

Davis: So in the return bucket you'll find things like value funds, funds that bet on the momentum factor, then you have these low-volatility funds. Investors can see all of these funds and they wonder, well, how do I put them together in a portfolio? So what's the best way to put these together without just simply replicating the market at a higher cost?

Johnson: Right. And that's very important to understand. So it's important to understand that if you are looking to use individual factor-based funds, so a value fund, a growth fund, a momentum fund, a quality fund. How can you sensibly recombine these factors in a portfolio and at the same time avoid just recreating a market portfolio in a relatively high-cost fashion when you've got very cheap liquid beta funds that are broadly available already?

What I would say is to look at funds that are tracking benchmarks that are sensibly constructed, that combine complementary factors. So factors that have a low degree of correlation to one another, meaning one will tend to zig when other one zags. And I think the classic case in this example is value and momentum, which are sort of the peanut butter and jelly of factors. So it's two factors that have been vetted across various time periods, across various geographies, across all asset classes. And what we see is, when you combine those because they have a low degree of correlation to one another, you get an overall portfolio profile that provides superior risk-adjusted returns relative to a traditional cap-weighted benchmark and doesn't simply bring you back to just broad beta in a very high cost fashion.

So it's important to understand, which factors work well together. There is also increasingly a number of multi-factor strategies out there that seek to do this on your behalf. So to understand whether or not those multiple factors in that portfolio do exactly this -- complement each other nicely -- are transparent, sensible and more than anything available at an attractive price point that are not paying active prices for a passively managed index fund.

Davis: I think one of the risks of investing in these strategies -- I guess a risk for any sort of investment -- is not knowing what you're getting into, and so therefore investors may have inflated expectations. So a great example recently is low-volatility strategies have done really, really well globally. And so in Canada at least money has just poured into these things. Which sort of environment will they not work in?

Johnson: So, if you look at low-volatility for example, I think that's a perfect case and point of the need to manage your expectations appropriately and to understand in what type of market environments will this strategy look and feel smart and in which types of market environments will it feel less so. So low-volatility strategies will tend to underperform in bull markets like the one we've been in for some time now. They'll leave some of that upside on the table, but to compensate that what you've seen at least historically is that low-volatility strategies tend to have far lower drawdowns in bear markets relative to traditional cap-weighted strategies.

So that's really where you're making your money in low-vol strategies during the depth of a bear market. You're not touching the bottoms that a cap-weighted parent benchmark might touch. But what you're sacrificing in return is some of that of upside that you might experience during the course of the bull market and you're only going to experience that if first and foremost, you maintain your investment in that strategy across that full market cycle.

So what we've seen is that the low volatility anomaly -- this idea that risk over a very long period of time is not necessarily related to long-run returns -- it's there. It seems to be fairly real, but you will only harvest that excess return if you stick to your guns through thick and thin and that's the most important element of all of this is that investors need to use these well and it may be difficult to do.

Davis: That's just the age-old problem, right. Really great funds but investors use them in the wrong way.

Johnson: Absolutely.

Davis: So last question for you. Do you think that strategic beta may sow the seeds of its own destruction? Meaning if everybody invests in momentum-driven funds or everybody is trying to play the value factor, then smart beta just becomes beta.

Johnson: Yes, it becomes an instance of the observer effect. So by virtue of observing and looking at the historical data and realizing that these risk premia exist and then offering and implementing a strategic-beta ETP that makes such a strategy broadly available at a very low cost to a very broad investor base, does that potentially chase away those returns that have been observed historically? And I think we have some very real precedents for this. I think if you look at what's happened in the commodities markets since the returns and sort of the risk profile of commodities, were documented by academia, what you've seen is sort of crowding in commodities and those returns that showed up in sort of the academic literature are yet to be experienced by investors.

You see this in asset classes like REITs whereby before REITs were included in broad benchmarks, they appeared to be non-correlated, really sort of attractive diversifiers in a portfolio context. But once they became more mainstream their performance, their addition that increment that they provided to a diversified portfolio looked more ho-hum.

So the risk here is that everybody crowds to one side of the table and nobody is left on the other side of the table to take the opposite side of that bet and the sustainability of these risk premia and that excess return is contingent upon there is always being an adequate supply of investors on the other side of the table to take the opposite side of these bets that you're making by a strategic-beta ETP.

Davis: I think you mentioned the value of momentum factors. To me they seem to be the most sustainable because there's a human nature element to both of them. In the case of value stocks, people don't like value stocks because they are not sexy, and therefore, investors underestimate their prospects. Is that how you see it?

Johnson: It's absolutely I think fundamental to just sort of human nature and human behaviour. It goes back to our very sort of primordial fight-or-flight instinct whereby when there's blood in the streets, many people tend to flee the streets and to sell out of markets and liquidate their portfolios and when things are going well people tend to pile on and oftentimes pile on at or near the top. So I think the behavioural element that underpins some of these phenomena is in all likelihood not going to go away anytime soon though. We can't discount the possibility that it might diminish somewhat or that the premium to trying to harness that are exploited might diminish somewhat over time.

Davis: It reminds me the paraphrase of Warren Buffett, if you have a good idea you should just keep it to yourself; once it gets out there investors will exploit it and the opportunity just disappears.

Johnson: Yes.

Davis: Well, thanks for joining us, Ben.

Johnson: Glad to have been here.

Davis: I'm Christopher Davis with Morningstar.ca.

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Christopher Davis

Christopher Davis  Christopher Davis is Director of Manager Research at Morningstar Canada.