Take care with smart-beta investing strategy

Take care with smart-beta investing strategy

Take care with smart-beta investing strategy by Dani Burger

Turns out, one of the hottest parts of the $2.3-trillion ETF industry has a little-noticed quirk with the potential to blindside users.

Fund titans like BlackRock Inc. and Invesco Ltd. have amassed billions in assets by selling their clients on smart-beta ETFs. By using computer models instead of human judgment to target strategies like growth or low volatility, they aim to combine the best of both the active and passive worlds. The pitch has helped swell assets in the ETFs by almost $30 billion this year.

Yet for all their popularity, there’s an inconvenient fact that even the most sophisticated investors may be overlooking.

In mutual funds, when a value manager strays from his mandate and ends up owning a bunch of high-priced growth stocks, they call it style drift. While the algorithms that do the stock picking in smart beta are too clever for that, a related hazard exists. It’s when funds tuned to one strategy start to be influenced by another: a low-volatility portfolio that gets infused with momentum stocks, for example.

“You can use smart beta for implementing factor investing, but you have to be very careful with how you do it,” said David Blitz, Robeco Asset Management’s head of quantitative equity research, who published a study in April about the complexities of using smart-beta indexes in pure factor investing. “What you end up with is very different than what you had in mind.”

Unintended exposure caused annualized returns for smart-beta ETFs tied to dividend stocks to vary by as much as 80% over the past 10 years, according to a research paper by Northern Trust Corp. It’s a big enough concern that the Chicago-based firm developed a rating system for how closely funds track their goal.

Nobody’s saying the fund providers are to blame, or that they’re trying to dupe unwitting investors. Basically, the issue comes down to simple math and the difficulty of isolating single characteristics, or factors, in baskets of stocks that don’t go short. And how much anyone should care about this depends on whom you ask. Northern Trust markets ETFs designed to root out impurities, while BlackRock says people who use its products correctly won’t be harmed.

“It doesn’t alter the risk reduction characteristics at the portfolio level,” said Robert Nestor, BlackRock’s head of iShares U.S. equity and fixed income smart beta strategy. The firm’s minimum volatility ETF “is designed to deliver roughly market returns with 15 to 20% less risk, and that’s exactly what it’s done since inception.”

Low-vol ETFs have been a goldmine for Invesco’s PowerShares and BlackRock’s iShares franchises in 2016, amassing the bulk of the smart-beta inflows. As a buyer, you might think you’re getting an exchange-traded fund with shares that don’t jump around too much. And almost always, that’s true. But using Bloomberg’s portfolio analytics tool on their low-volatility ETFs also shows your fortunes can also align with stocks that have the highest price momentum or valuations, in addition to what you paid for.

It’s no small matter. As the investing public embraces passive investing, fund companies have used smart beta to offer a wider array of ETFs that focus on specific characteristics. Today, one in five U.S.-listed ETFs uses smart beta while more than $400 billion is tied to the strategies.

Smart-beta ETFs are prone to the same influences that affect any portfolio as circumstances in the market change. One reason is that many use relatively simple methods to rejigger their holdings -- pick the 200 least-volatile stocks in the S&P 500 and build a security out of it, for example.

Perhaps the most famous example occurred in May, when the $7.94 billion PowerShares S&P 500 Low Volatility Portfolio started posting bigger price swings than the tech-heavy Nasdaq Composite Index itself. Some analysts have speculated the sheer popularity of the fund has been behind the turbulence. In the first half of 2016, the ETF had more than $1 billion of inflows, putting it on track for its biggest ever year.

“I don’t think investors should be concerned by it, but they should be aware,” said Todd Rosenbluth, the director of ETF and mutual-fund research at S&P Global Inc., which compiles the index underpinning the PowerShares low-volatility fund. “If you’re holding on to them for a longer period during a full market cycle, which is how they’re intended, it shouldn’t matter as much.”

Bloomberg News

Related stories:
New pay-for-performance fund to offer investors something different
Sphere latest David to take on Goliath in ETF space