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October 20, 2014

Monday Morning Memo: From smart-beta investing to factor investing

by Detlef Glow.

Looking on the headlines in the European ETF industry, it sems to be, that the so-called smart-beta investing is a hot topic. But what is meant by smart-beta investing? The term smart beta has been created to describe indices which are employing market factors like valuations (fundamental data), company size, volatility or momentum, to select the constituents of the respective index. It has been shown by academic research, that these factors can be used to achieve premiums compared to the overall market returns, i.e. these indices claim to improve the returns, compared to capitalization-weighted indices, by using systematic tilts toward classic factor premiums.

Source: REUTERS/Mike Blake

Source: REUTERS/Mike Blake

Based on the factors mentioned above, there are different strategies—such as fundamental, equally weighted, low/minimum variance, maximum Sharpe ratio, equal risk contribution, or momentum indices—that are followed by ETFs to capture the premiums offered by each factor. In other words, the factor exposure explains the risk/return profile of the indices.

Since much of the sales process of mutual funds and ETFs is done by product marketing, European ETF providers have found a number of different names for their smart-beta offerings to differentiate themselves from their competitors. From my point of view the industry should not use different terms for these strategies; instead they should use the term “factor investing,” since this really describes what the index/fund is doing. Otherwise, it could happen that investors won’t buy a fund because they do not understand why one promoter is using a different vocabulary to describe the same strategy as one of its competitors.

Graph 1: Timeline of launches of factor-investing strategies, January 2011 to August 2014 (Euro Millions)

14-10 Timeline new smart beta ETFs

Source: Lipper

This could also be one reason that ETFs based on factor indices have not gathered more money in the past. Even though this market segment is rather new to the market and has shown good growth, it may have been possible that ETF promoters could have gathered even more money.

Graph 2: Assets under management of ETFs that replicate factor-investing strategies, January 2011 to August 2014 (Euro Millions)

14-10 AUM Smart Beta

Source: Lipper

Another reason investors might be shy about buying into factor-based indices can be seen in the fact that the index concepts are rather complex and lead to a lot of activity on the constituent level. In this regard some market participants see factor investing as an active strategy and call ETFs that follow these strategies active ETFs. But this is only half the truth. The ETF by itself is a passive vehicle that replicates its underlying index, and in the case of factor investing these indices can be called active because of the very high turnover of constituents in some cases. This combination has implications for the research one needs to do to select funds that follow a factor-investing index.

Research on factor-investing ETFs

As implied, factor investing indices stand in the middle of the product range, since the indices are sort of active, while the products themselves are passive. This means that a successful research approach must contain elements of active and passive fund analysis. The wrapper must be analyzed the same as any other exchange-traded product (ETP) by using screens to show tracking error, excess return, liquidity, trading costs, etc., while the index must be analyzed like an actively managed product. In this regard analysts/investors need to make sure they understand the strategy employed by the index, since it is the main driver of the index’s performance.

Since the segment of factor-investing indices and ETFs is rather new, analysts might not be able to do their quantitative screenings based on real data; in many cases most of the performance analysis provided by index or ETP promoters is based on back testing. Nevertheless, it is very helpful to run the respective analysis on long-term data sets to evaluate the behaviour of the factor strategy in different market environments. This analysis shows in which market circumstances the strategy might work and those in which it will not. With regard to this, it is noteworthy that the academic research shows that none of the factors, even though they have outperformance over the long term, show a consistent outperformance in any given environment. The investor must make an estimate of the future market environment and then choose the factor-investing strategy that should profit the most in that environment.

I see factor-investing products as one of the drivers of future growth in the European ETF industry, since many of the strategies imply they can help investors improve their returns or better use their given risk budgets. But to achieve this outperformance the index and fund promoter need to explain the rather complex strategies in simple terms for their investors, since the investors might not buy a product they don’t understand.

The views expressed are the views of the author, not necessarily those of Refinitiv.

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