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Portfolio > ETFs

Is Strategic Beta Too Smart for Its Own Good?

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Smart beta (strategic beta, factor) strategies came on the financial scene years ago and allowed investors — instead of buying the full market index — to incorporate rules that allowed them to focus on key strategies. For example, for a low-volatility strategy, a smart beta ETF would provide exposure to the least volatile stocks in the index. Today there are 642 strategic beta ETFs, which is 21% of the ETF universe, according to a new study by Cerulli Associates.

But despite having a “sensible value proposition,” smart beta strategies aren’t garnering wide acceptance by advisors, yet. According to the Cerulli survey, only one in five advisors now use strategic beta products in their portfolios, while 71% don’t know whether these strategies are supposed to produce alpha or outperform. Further, 67% of advisors in the survey stated they lacked familiarity with strategic beta strategies.

The confusion may be due to how issuers promote their product as well as the complexity of the products themselves, notes the report. “A key challenge for strategic beta strategies … is the difficulty that advisors face in interpreting the strategies,” the report states. “Cerulli believes that the increasing intellectual capital required to understand the products, and key discrepancies in how they are positioned, hinder product use.”

The low number of advisors using the product was a surprise to Cerulli. “[It’s] a smaller portion than would be expected given the wide availability and product development focus,” said Daniil Shapiro, associate director at Cerulli, in a statement.

How issuers position strategic beta ETFs is a problem, Shapiro added. In fact, 68% of issuers sold the product as providing specific factor exposures, while 50% state the products generate alpha. “Advisors, meanwhile, report using strategic beta products based on their desire for key outcomes, particularly downside risk protection and reducing portfolio volatility,” Shapiro said.

Specifically, Cerulli found a disconnect between what advisors want and what issuers recommend. For example, while only 21% of advisors said they used smart beta ETFs to provide exposure to specific strategies, 68% of issuers suggested smart beta ETFs for that usage, as Shapiro noted. Likewise, only 15% of advisors were using the product to produce alpha, while 50% of issuers said they were suggesting ETFs for that purpose. The two areas advisors and issuers were closest were using strategic beta ETFs for downside risk protection (46% advisors, 50% issuers) and to reduce portfolio volatility (36% advisors, 54% issuers).

Despite the confusion, issuers now are launching multifactor ETFs: 166 were available by the end of 2018, noted Cerulli, and this has led to increased complexity in a product that already has “challenged advisor adoption,” the report states. “With performance varying widely between products, advisors will be hard-pressed to make a defensible investment decision,” Cerulli states.

Of those advisors who do use strategic beta products, 42% always use them for their own investment decisions, while 54% sometimes use them in those cases, according to the survey. Sixty-one percent sometimes used them from their firm’s recommended ETF recommended list, 62% sometimes used them in the firm’s ETF model portfolios, while 66% sometimes used them with third-party models, such as Dorsey Wright.

The paper recommends that “advisors use strategic beta products to fine-tune investments in line with their client’s goals (e.g., a low volatility factor product for a client with a lower risk tolerance).” Further, it recommends issuers focus on product education “from an outcome perspective verses positioning individual products based on their potential to outperform.”

A counterweight to the Cerulli report comes from Michael Natale, head of intermediary distribution for Northern Trust Asset Management, an early pioneer in smart beta — or as they prefer to call it, factor investing — who says his personal experiece doesn’t bear out Cerulli’s findings on advisors shunning smart beta. “We certainly aren’t feeling that in our interactions with advisors,” he told ThinkAdvisor.

He also sees factor investing growing, especially with the slowing or end of the bull market. (The Cerulli report noted there were $702.4 billion in strategic beta ETFs as of 2018, up from $99 billion in 2009).

“You’re going to start to see people, especially in an environment of volatility, say ‘I just can’t ride an index up and down, I need to find something that’s going to be tied to outcome,’ because more and more advisors are trying to solve for outcome,” Natale says. That said, he does concede that there is a large “educational component to factor investing.”

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