So-called “smart beta” exchange-traded funds (ETFs) may be a relatively small slice of the ETF pie, but they are the fastest growing segment of that pie.

“Intelligent indexing is gaining momentum; it’s the next generation of ETFs,” says Michael Cooke, head of distribution for PowerShares Canada, a division of Toronto-based Invesco Canada Ltd.

Although there is boundless choice in the number of strategies that fall under the smart beta (also known as strategic beta, intelligent indexing or factor-based) label, what these strategies have in common is that they add a twist to the traditional, index-based ETF strategy of weighting securities based solely on market capitalization. Instead, smart beta ETFs track customized indices for which the securities selection is based on a host of other factors that could include anything from equal weighting to fundamental characteristics.

“Broad market indices are useful for measuring the performance of the market, but I don’t like them as a basis for an investment strategy,” says Som Seif, president and founder of Purpose Investments Inc. of Toronto. “With intelligent indexing, you can be thoughtful about the rules and how you invest money. Broad market indices are not in my DNA.”

With smart beta, there is some judgment and decision-making applied when the underlying indices for an ETF are designed. After that, the ETF’s portfolio is adjusted automatically, according to the predetermined parameters for securities selection. Portfolios tend to have low turnover and don’t change except for quarterly or monthly rebalancing, when holdings are adjusted according to the ETF’s rules for securities weighting and inclusion.

“By providing access to specific investment factors that affect risk and return, smart beta ETFs offer the opportunity to reduce risk and/or potentially outperform the cap-weighted indices,” says Cooke. “At the same time, [smart beta] offers all the benefits of ETFs, such as transparency, cost efficiency, liquidity and tax efficiency.”

Multiple factor screens

Essentially, smart beta is at the intersection of fully active and passive investing. Fees for smart beta ETFs tend to be higher than those on plain-vanilla index ETFs, but still are significantly lower than fees for actively managed mutual funds because of the ETFs’ low maintenance, automated approach.

“Costs are compressing with ETFs. And for what it would have cost to obtain simple market beta a few years ago, you now can access a more active, smart beta strategy,” says Trevor Cummings, head of ETF business development at RBC Global Asset Management Inc. of Toronto. “The strategies are always rules-based. There’s no manager stroking his chin and making decisions with his gut.”

On the equities side, smart beta ETFs could include exposure to securities based on such factors as equal weight, fundamental characteristics, low volatility, high dividend yield or price momentum. On the fixed-income side, characteristics such as credit risk and bond duration might determine eligibility for inclusion in a customized index. Increasing, smart beta ETFs are of the multi-factor variety, encompassing a range of factor tilts and exposures in one ETF, creating a higher due-diligence burden for financial advisors in assessing an ETF’s characteristics, while, at the same time, providing a path for advisors to add value.

“We’re seeing continued product development in the smart beta space, and it’s evolving to include multiple factor screens,” says Barry Gordon, president and CEO of First Asset Investment Management Inc. of Toronto. “It started with ETFs screening for characteristics such as momentum, value or volatility, but we’re now seeing these being put together in various combinations.”

The market share of smart beta ETFs is growing rapidly. According to figures supplied by Morningstar Canada of Toronto, as of Feb. 28, smart beta ETFs accounted for $9.1 billion, or 11%, of the $81.4 billion in total Canadian ETF assets under management (AUM). During the previous three years, AUM for the entire ETF industry in Canada grew by 67%, while “regular” ETF AUM grew by 61% and smart beta ETF AUM grew by 132%.

Like a human being maturing from childhood into adolescence, ETFs are becoming increasingly complex, complicated and unpredictable at the same time as they are becoming more talented and sophisticated. The growing complexity of smart beta makes close examination of ETFs essential for advisors to ensure that the chosen ETF provides the desired asset-class exposure and that there is an adequate liquidity in the ETF’s underlying investments.

As of Feb. 28, the biggest smart beta ETFs were iShares Select Canadian Dividend ETF, with $1.5 billion in AUM; iShares S&P/TSX Canadian Dividend Aristocrats ETF, with $1.2 billion in AUM; and BMO S&P/TSX Equal Weight Banks ETF, with $628 million in AUM.

“The barriers to entry in the ETF business are low, but the barriers to success are just as high as they’ve ever been,” Cummings says. “Factor-based ETFs blur the lines between traditional active management and traditional ETFs, and [factor-based ETFs] are the area in which we’ve chosen to position ourselves to focus on income solutions. If you’re a new entrant in the world of broad-market ETFs, the only lever you can pull to compete is lower costs – and that’s not where we want to compete. With the factor-based ETFs, experience and innovation rise to the fore.”

Strategies that seek to improve returns or reduce risk relative to a standard benchmark need to be tracked carefully over a meaningful period to ensure they are delivering an advantage and not just a “more costly way to skin the cat,” says Ben Johnson, director of global ETF research at Morningstar Inc. in Chicago. With ETFs that incorporate a range of factor tilts and exposure, he adds, due diligence needs to be as rigorous as the process an advisor or investor would undertake in scrutinizing mutual funds’ active portfolio managers. Many smart beta ETFs also have short track records, he warns.

Exposure to different risks

“We call them ‘smart beta’ or ‘strategic beta’ ETFs, but some are long on marketing hype and short on substance,” says Johnson. “These ETFs are a vessel for some kind of active bet vs traditional exposure. But the strategies are not all smart and some are not smart all the time, and clients must have the appropriate expectations. For example, a ‘low volatility’ or a ‘value strategy’ ETF can lag in bull markets.”

Smart beta ETFs expose investors to different risks than do passive ETFs that are based on market-cap weighted indices. For example, cap-weighted indices add to the weight of the companies as their prices – and, therefore, their market cap – rise, which can result in a high price/earnings ratio within the ETF and often creates overconcentration or an “unintentional bet” on stocks that have rising momentum.

On the other hand, a smart beta ETF makes an “intentional bet” through customized strategies that may or may not beat the overall market. For example, smart beta ETFs with a value tilt could be more heavily weighted in securities that temporarily are out of favour. Investors need to be willing to hold their ETF investments through periods when the strategy is lagging in the hopes of reaping long-term rewards.

“An ETF with a global value strategy would be overweighted in Russia right now, and investors would have to be prepared to hold uncomfortable positions,” says Brent Leadbetter, vice president, client strategies, with U.S.-based Research Affiliates LLC, a developer of smart beta and asset-allocation strategies. “Advisors must assess their clients’ risk tolerance. You don’t want them selling the day before Russia goes for a ride.”

There’s growing awareness that not all ETF benchmarks and customized indices lend themselves to easy duplication, Cooke says. Even ETFs that track the same market can provide different returns, depending upon the methodology behind the creation of the underlying basket of securities holdings, the liquidity and weighting of the underlying securities, and the rebalancing strategy.

“Providers of ETFs must create a methodology or customized index that’s investible,” Cooke says. “If the number of securities is unwieldy or some are difficult to buy and sell, that particular portfolio may look good on paper but doesn’t lend itself to implementation.”

© 2015 Investment Executive. All rights reserved.