Strategic beta – commonly known as smart beta – ETFs are growing in popularity in Europe. They already account for 8 per cent of the assets invested in ETFs and the growth outlook remains positive, with an average of 10 to 15 per cent of monthly net inflows into ETFs in Europe directed to these types of products. Thus it should come as no surprise that ETF providers consider smart beta as one of their key business areas for the coming years.
Constant innovation is imperative in smart beta benchmark development, not to mention a way for ETF providers to differentiate themselves and capture market share in what is becoming a very dynamic marketplace. This means that a substantial share of the product development budget, both of index and ETF providers, is being devoted to researching and bringing a raft of ever smarter strategies to the marketplace.
In absolute terms, the bulk of assets in smart beta ETFs in Europe are still located in products providing exposure to single factors. For example, ETFs tracking dividend-screened/weighted equity strategies remain particularly popular, as investors continue to favour ways of improving income streams in the current ultra-low interest rate environment. But when it comes to product development, the European ETF market is already in a phase where new single-factor funds are simply filling in missing geographical spots.
Multi-factor strategies are the natural evolution in the field of smart beta, and the place where product research and innovation currently thrives. Multi-factor smart beta ETFs are marketed as investment solutions that address the most obvious shortcoming of single-factor equity exposures, namely their cyclicality. Indeed, when it comes to investing in equity factors, the old adage of ‘don’t put all your eggs in a single basket’ also applies.
The question for index and ETF providers is how to combine factors in the most efficient way to improve the overall risk-return profile of the multi-factor fund while minimising turnover costs.
The most straightforward way of combining any range of factors, and certainly the simplest for investors to understand, is to follow an equal weighting approach. Some of the early multi-factor smart beta ETFs launched in Europe followed this tactic.
However, we are now seeing further evolution in product development, with many of the new offerings coming to the market built following a ‘core-satellite’ framework, where one of the factors acts as the core building block and the rest – whether just one or a combination of several – address the potential downsides of its cyclical nature.
Quality-dividend indices and the ETFs that track them are a good example. These products screen dividend-paying companies for quality, favouring the more profitable and less indebted, with a view to delivering a less volatile income stream over the long term.
Other products use low volatility as a core factor exposure and complement it with quality, value or momentum.
Some may argue that rather than multi-factor, this really is ‘single-factor 2.0’, as the key focus of the product development process and subsequent marketing efforts is on the core factor of the structure.
Regardless, it is fair to expect more products of this type entering the market. After all, multi-factor ETFs can be churned out in many different combinations. This will make the task of benchmark and ETF selection ever more complex for investors.