In the US, advisers building ETF-only strategies have grown substantially and at the end of March 2016 managed total assets of $76bn from 156 firms.
In the UK, while not at the same level, there is considerable interest in adopting similar strategies based on ETFs. Part of this shift in adoption was driven by the retail distribution review and more recently by the advent of robo-advisers. In both cases the low cost, efficiency and breadth of asset choice and fund exposure have helped put ETFs at the forefront of investment opportunities.
The longer term trends of investors focusing on costs, returns, risk management and diversification suggest that the evolution away from traditional mutual funds to ETFs is definitive as opposed to fleeting.
An early part of the shift in assets and strategies has been centred on the transition by advisers to the increased use of passive funds. This has been driven by the lack of stability of alpha generation by active managers and a focus on pure market capitalisation index-based exposures in both the equity and fixed income space. While the shift to well-known and high-profile traditional indices, such as the FTSE 100, S&P 500 and MSCI Europe, has been well documented, the market has continued to evolve.
Over the past few years there has been a more nuanced focus on newer strategies that help solve the challenges of a low interest rate macro-economic environment and can help advisers build more solutions-based portfolios.
Typically, this trend has been epitomised by increasing use of smart beta indices, which tend to offer strategies that are different from pure market capitalisation exposures and aim to provide alternative outcomes. This means advisers can build different risk-based portfolios and achieve varying profiles that reflect investor preferences including income generation, global diversification, long-term enhanced risk-adjusted returns and multi-asset portfolios.
Smart beta has become an important tool in financial advisers' kit as ETF issuers focus on the key challenge, which is education. Once advisers have a thorough understanding of how differentiated smart beta ETFs tend to be from their plain vanilla market capitalisation weighted counterparts, the value proposition becomes clearer and more accessible.
Some of the most popular smart beta strategies today deliver powerful solutions to common investment challenges. At the forefront of advisers' minds have been key themes such as income generation, low volatility, risk management and asset class diversification.
In each case there are smart beta solutions that cannot be matched by market capitalisation-based funds or active strategies.
Smart beta is also increasingly gathering assets that would have historically gone to active managers and in these instances the focus is not just on low cost and efficiency. One of the most important aspects of smart beta ETFs that has truly caught the imagination of advisers is an understanding that they can offer similar exposure to active styles, but in a systematic and more risk controlled framework.
The consistency of returns and style exposure is an important aspect of why these ETFs can be seen as an efficient replacement for traditional active solutions. In Europe, Smart Beta ETF AUM has risen from €6bn in 2011 to €30bn at the end of 2015.
Smart beta ETFs follow rules-based quantitative strategies and, in some cases, these strategies can have a live track record of more than ten years. This is a rare and important feature. The value of a live record is well recognised by investors, especially in the context of strategies that can be used to replace active managers.
As advisers have become increasingly comfortable with the underlying methodologies employed in smart beta ETFs, so they have become more willing to recommend them to clients and incorporate them into multi-asset portfolios.
There is little to suggest that this trend should change as smart beta and products continue to evolve to focus on strategies such as the core factors of value, growth, quality, yield, small cap, liquidity and momentum.
Smart beta has fundamentally changed the investment landscape and opportunity set of advisers and their end clients. The added value ensures the products will remain relevant as markets develop and change.
One aspect of the financial crisis of 2008 was that while active managers typically underperformed there was also little value in being in a market capitalisation benchmark product that may decline by 50 per cent. This type of end result has created the demand for products that are more suited for long-term investment outcomes and opportunities.
Enhanced index methodologies that typically underlie smart beta ETFs are not only available in equities, but have also spread out to areas such as commodities. In this asset class, where the cost of owning commodities can have a deleterious impact on returns, smart beta strategies that look to minimise the cost of ownership can deliver fundamentally different returns.
Broad enhanced commodity strategies have both low volatility and low correlation to other asset classes, thereby ensuring a place in client portfolios through the benefit of diversification and risk management.
Portfolios of ETFs represent the way forward for many advisers in an ever-changing investment landscape. ETFs offer one of the most transparent and low cost investment vehicles while smart beta strategies deliver differentiated products that address key investment challenges.
In the UK the last remaining barrier to adoption of smart beta ETFs is one of product access on the platforms typically used by financial advisers. However, the twin drivers of platform consolidation and demand-led change are ensuring that ETFs are visible and playing an increasingly important role in building portfolios.
Smart beta strategies, as they evolve and become available via ETFs, can ensure that financial advisers have the choice of sophisticated solutions that match their clients' requirements. Innovation in smart beta strategies ensures they can remain relevant in the fast changing investment landscape.
Nizam Hamid is head of sales at WisdomTree
Key points
Smart beta has become an important part of the toolkit for financial advisers
Smart beta ETFs follow rules-based quantitative strategies
The last remaining barrier to adoption of smart beta ETFs is one of product access on the platforms
