Private View Blog: Time for smart beta strategies to prove their worth

Speak to any ETF provider and they will wax lyrical about innovation in the industry, the new products they have rolling off production lines, the hard to reach asset classes that these wrappers are able to access.

They talk about how investors are now used to using ETFs in their portfolios, and how, having tried, and liked, these products, they starting to move into the more exotic parts of the market.

Yet the fact remains that the big sellers are still the plain vanilla, market cap-weighted funds tracking major indices. The original SPDR, S&P 500 fund is still one of the most popular products out there today. And these continue to get cheaper as providers undercut each other, for example the launch of Lyxor’s “core” ETFs last year.

It is these ETFs which hold the greatest attraction for wealth managers. As Fahad Kamal, chief market strategist at Kleinwort Hambros puts it, if you are looking at a market in which is hard to find alpha, then you may as well use an ETF as it is the cheapest way of gaining access and they do the job well. He mentions the likes of BlackRock, Fidelity, Vanguard and Lyxor as the providers the wealth manager might use. “We use those guys simply because they are cheap, effective and cheerful,” says Mr Kamal.

The ETF industry remains very concentrated. Globally, the top three providers account for 69 per cent of all assets, according to ETFGI. In the US that rises to 81 per cent. And the 634 products which are $1bn or more in size hold 85 per cent of all assets.

The big boys already have this corner of the market sewn up. “That is a challenge for providers looking to come to market,” says Deborah Fuhr, managing partner at ETFGI. So the newer, or smaller, firms need to find new areas in which to try and carve out a niche. Hence the cascade of product launches in area such as fixed income, commodities and in so-called “smart beta”. This has undoubtedly been great for innovation in the ETF sector, but it remains to be seen how popular these products are with investors.

All wealth managers are aware of smart beta ETFs – they have received so much press it would be impossible not to – but the uptake has not been as big as many were predicting a few years ago. When asked if they use them in private client portfolios, the overwhelming response tends to be ‘in certain circumstances for select individuals’.

The providers are, of course, upbeat. “The easy stuff has been done, but it is a competitive space and we think we have a lot to add,” says Bryon Lake, once of Invesco Powershares but now heading up JP Morgan Asset Management’s international ETF business.

Some areas do seem ripe for growth – fixed income ETFs, for example, were much slower off the mark than equity and with yield so hard to come by in the bond world, paying less for a product seems a great way to make the most of what is out there. And a more active approach makes sense in this market, rather than simply allocating to the most indebted companies as some passive funds do. There is alot of talk about ESG strategies, which would tap into demand for sustainable investment options.

Other parts of the market might find the going tougher though. ETFs have enjoyed one of the longest bull runs in history, with QE lifting all boats with the tide and making life extremely tough for active managers.

That looks set to change. The economic cycle is ageing, central banks are trying to return to less accommodative monetary policies, and investors are starting to hoard cash and see how things pan out.

If volatility is coming back to markets, which seems to be the case, along with dispersion within, and between, asset classes, then we are likely to be entering a period where active managers are once again able to earn their crust.

Growth in the ETF industry has been spectacular, and this is set to continue, despite the challenges facing the global economy and asset managers in general. A recent report from BMO Asset Management projects the global ETF industry will double over the next five years.

The big ETFs which provide building blocks for investors will continue to do well in such an environment, as they will still provide cheap and easy access to markets. But quite how smart beta products will fare is another matter. Many of these funds are relatively new, and do not have the track record to demonstrate how they might get on in turbulent markets.

As Mr Kamal at Kleinwort Hambros puts it, many investors would rather give money to an active manager to try and find opportunities in this market environment rather than put their faith in an untested, rules-based strategy.

If smart beta strategies perform as promised over the next few years, then they will at last be able to display track records that have been tried and tested in difficult markets. The rewards for those that do well could be considerable.

Many providers have bet a lot on smart beta taking off. The coming months and years will be a big test for them and the strategies they have put so much faith in.

Elliot Smither is chief sub editor of Professional Wealth Management. Follow him on Twitter @ElliotSmither

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