Content provided by Rusty Vanneman, CFA, CLS Chief Investment Officer
Smart beta ETFs, sometimes known as strategic beta ETFs, represent the fastest-growing segment of the booming ETF landscape – and for good reasons.
In 2014, smart beta accounted for $170 billion in assets, according to a report for Institutional Investor by Howard Moore. The concept goes back decades, but the popularity of smart beta ETFs is rooted in the risk-averse aftermath of the 2008 financial crisis. As Moore writes, with interest rates near zero, bond yields sluggish, and an equities market that “has ramped up disproportionately to economic growth,” investors need new ways to get returns, but they still don’t have the stomach for risk. Smart beta ETFs can meet that need. There are rules-based portfolios typically based on factors that have been studied to show they can have long-term performance advantages. They provide transparency and the potential for higher returns without too much risk.
At CLS, we believe smart beta ETFs have distinct advantages for a couple reasons.
First, they provide the essence of active management at a fraction of the cost. That’s the reason they are taking market share from actively managed mutual funds like crazy. For instance, why buy a mutual fund with an expense ratio of 1.50% per year, when you can buy an ETF largely doing the same thing (such as value investing or dividend investing) at 0.25% per year? That’s a mighty big head start for the smart beta ETF’s potential performance. In addition, smart beta ETFs don’t have a portfolio manager waking up on the wrong side of the bed or getting sick. It closely tracks indexes by itself. If the biggest key to investing success is discipline – and it is – then an ETF staying on top of its benchmark and following its investment philosophy and process to the T is about as disciplined as it can get.
Second, smart beta ETFs will likely also take market share from vanilla, cap-weighted ETFs. Why? Because smart beta ETFs in theory (and historically) have a performance edge, or at least most of them do. Factors such as quality, size, or value have all shown they can add incremental value over the long term (though, like all investments strategies, they can underperform over shorter time periods).
We use smart beta ETFs at CLS, and we will likely continue to increase our use of them in the years ahead.