Last year was supposed to be a banner year for smart beta ETFs in the U.S., but that didn’t happen, according to Morningstar. Inflows into strategic beta ETFs — Morningstar’s term for ETFs for funds focused on specific investment factors — decelerated from the previous year despite the fact that inflows into ETFs overall rose 61% as investors favored plain vanilla market-weighted index ETFs with lower expense ratios.
That focus on lower costs “disadvantages somewhat these newer, more nuanced, more complex and more costly strategic beta ETFs,” said Ben Johnson, Morningstar’s director of global ETF research, in a published interview with Morningstar’s director of personal finance Christine Benz.
It may also disadvantage investors. “If they are to focus on what are ever-smaller differences in fee levels, they run the risk of overlooking the fact that many of the indexes that underpin these funds are going to deliver vastly different outcomes even though they might have similar labels,” added Johnson.
Todd Rosenbluth, senior director of ETF and mutual fund Research at CFRA, takes it a step further. “Understanding an ETF’s performance record or its ability to replicate a unique index does not help investors determine what will happen in 2018. Only a review of the holdings can provide that,” he writes in a recent commentary. Moreover, since those holdings can be reconstituted on a regular basis — the frequency depends on the fund — “further due diligence is required,” says Rosenbluth.
(Related: Goldman Starts Smart Beta ETF Price War)
Rosenbluth, along with other analysts, expect that low-volatility funds will generally outperform other smart beta ETFs in 2018, but advisors should note that the same forecast was prevailed for 2017 and low-vol funds have underperformed this year, largely because there was very little volatility in the market.
“Volatility as a factor is one of the most misunderstood,” says Alex G. Piré, head of client portfolio management at Seeyond, an affiliate of Natixis Investment Advisors. ”A lot tend to look at the aggregate level, measured by the VIX … We invest in low volatility using an active managment approach, buying lower-volatility securities, not sectors.”
Momentum was the star investment factor for 2017 — “investors were buying growth,” says Matthew Bartolini, head of SPDR Americas Research — and could still be a good play for early 2018 if earnings season is strong, says Rosenbluth. Advisors can check the momentum of individual ETFs using analytical tools like Trendrating, which measures the momentum of ETFs and other portfolios starting with the momentum of their individual stock holdings.
This year could also see growing demand for multi-factor funds, which typically integrate three to five factors such as momentum, value, size, low volatility and quality at the individual stock level. Such funds “can pack a stronger punch” than using a combination of different single factor funds, writes Alex Bryan, director of passive strategies research, North America at Morningstar.
“We expect 2017 will be a year when more advisors seek out multi-factor ETFs that feel more like active management than IVV [iShares S&P 500 Index ETF] and its market-cap weighted peers, but are cheaper than the 1.1% for a large-cap mutual fund,” says Rosenbluth. “If they do, we hope they finish their homework and look inside the portfolios first.”
— Related on ThinkAdvisor:
- Smart Beta Strategies More Popular Than Ever and Growing Rapidly: Survey
- Active and Smart Beta ETFs Record Robust Inflows
- Smart Beta: Which Strategy Works Best Over Time?