Are your clients sold on smart beta?

A Canadian PM explains why factor-based strategies may be just as vulnerable as more traditionally risky investments

Are your clients sold on smart beta?

With opinion split on when a market correction might happen, most investors are weighing up their options. There is little doubt that many will be attracted to low-volatility, smart beta ETFs in their search for protection. But according to Ted Theodore, CFA, Portfolio Manager of the TrimTabs Float Shrink ETF, these types of factor-based strategies may be just as vulnerable as more traditionally risky investments if there is a serious sell-off.

“There is a whole bunch of things going on as to why smart beta ETFs have become so popular, and one is the enormous ability of the financial industry to generate new product,” said Theodore. “The growth of ETFs has been spectacular, and part of that is to do with a compression of fees, which is a big selling point. But actively managed funds haven’t done that well compared to the benchmarks and they carry relatively high fees. So, if they don’t perform, what is the point of paying the fee?”

Despite believing that smart beta ETFs have lulled investors into a false sense of security and that they fall short of protecting against “financial engineering” risk, Theodore does concede that this new generation of funds do have a “modicum of academic research support”.

“It was originally just beta, but now the category includes size, quality, value, and momentum as factors,” he said. “The marketing side of this business has been saying ‘listen, we have learned people who say there is a premium for size or value or momentum’. All those things are at work in pushing the envelope of new issues.”

Theodore believes that the rise of the smart beta ETFs can also be attributed to the fallout from the financial crisis of 2007 – 2009 when the market slumped 53%.

“That was a life changing event for most investors and there is lots of evidence that shows people have continued to be cautious, even in the face of the market having tripled since March 9, 2009,” Theodore said. “But, it should probably not be surprising that sentiment remains. We had a similar example after the Great Depression. It took a new generation to discover stocks again; they didn’t really get a new gathering until the late 40’s.”

Investments in equity positions have been modest over the past nine years, which is unusual in such a strong market. It’s should be no surprise, then, that the current cycle has been labeled the least loved bull market in history.

“That caution gets translated into investors being more enamoured with mechanical approaches like a dumb or now a smart beta fund,” Theodore said. “There is a whole bunch of things going on as to why they have become so popular. It has been a phenomenon.”

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