Exchange-traded funds (ETFs)are expanding beyond index-tracking towards a more factor-based approach.
A focus on factors may provide improved clarity on what drives risk and return, and could give investors greater influence over active exposures in their portfolio at a lower cost than an actively managed equivalent, according to new research from Vanguard.
The investment house stated that the use of factor-based ETFs may allow investors to effectively manage their risk and return targets while giving control over the type and size of factor tilts – the investment goal on which the fund focuses.
This means investors could build targeted exposures similar to those that could be found in the objectives of actively managed funds, but with less cost and more transparency.
Factors are the underlying exposures that explain or influence risk – the component parts of a portfolio, determining how it behaves. Some commonly discussed factors include market, value, size, momentum, volatility, term, and credit.
A factor-based strategy could be a cost-efficient way for advisers to help clients meet their specific investment goals, Peter Westaway, head of investment strategy at Vanguard Europe said. “A better way to think about smart beta is as another way of factor investing. Factor-based strategies are a way to effectively replicate what a high-fee manager was doing,” he added.
ETFs have traditionally tracked an index, such as the FTSE 100. But focusing on a factor instead of an index could allow investors greater choice of their investment objectives, and, hopefully, improved transparency of underlying assets.
“It’s not that we don’t think there’s value in active management – there is skill to be found, but it is hard to find. More and more of these factor-based building blocks will be offered going forward,” Mr Westaway said.
Smart beta aims to break the link between market capitalisation – the number of outstanding shares multiplied by the price per share – from a security’s index weight.
ETFs have experienced a surge in popularity over recent years. In July alone, BlackRock reported inflows of $36.6bn (£23.4bn) into global exchange-traded products – the highest total for five months.
Chart 1 demonstrates inflows into global ETP assets since 2000. Equities comprise the majority of ETP investments, while fixed income and commodities have gained more investor attention since 2007.
While ETFs are often marketed as a low-cost investment strategy, 56 per cent of investors think that performance fees are a good incentive for fund managers to perform well, according to Henderson Global Investors research. Only 19 per cent of investors polled said that performance fees would deter them from investing in a certain fund.
Performance fees should work to align the interests of the fund manager with the shareholders, according to James de Sausmarez, director and head of investment trusts at Henderson. Instead of being put off by performance fees, investors and advisers should make sure that the fee structure works in the favour of the fund.
This should include characteristics such as a compensating low-base management fee, an appropriate level or returns that the fund must reach before the fee is paid, a fair cap on total fees, as well as a strict requirement that any underperformance must be made up for before a future performance fee is payable.
Advisers should ensure that their clients understand where their fees are going and why, and discuss any lower-cost alternatives that could deliver a similar investment objective.
