By Suzanne McGee
As individual investors flock to so-called smart-beta funds, the
question is whether they are doing so with all of the wisdom the
strategy demands, or simply chasing the latest trend the financial
industry is promoting.
Smart-beta funds -- which are also called strategic-beta funds
or factor-based funds by some -- track indexes in much the same way
passive investments do. The difference is that instead of weighting
holdings by market capitalization, the funds select securities with
qualities or "factors" that research suggests are associated with
outperformance or lower risk, such as earnings growth, value, price
momentum or high dividends.
According to data provided by research firm Morningstar Inc.,
assets under management in exchange-traded funds that it classifies
as taking this quantitative-based approach to investing have more
than doubled since December 2014, rising to $1.09 trillion as of
the end of September.
Invesco Ltd., one of the providers of factor-based vehicles,
calculates that for every $4 investors allocated to ETFs as of the
end of the third quarter, $1 went to an ETF employing some kind of
smart-beta strategy. Those asset gains came as advisers report
seeing more factor-based mutual funds in 401(k) plans and despite
underwhelming returns from some asset managers employing smart-beta
strategies over the past 18 months.
"Now that these products have accumulated a critical amount of
assets and have a track record behind them, that's helping with
their adoption" by both investors and financial advisers, says
Jason Stoneberg, senior director of ETF research and product
development at Invesco. "Investors are always looking for better,
more efficient ways to access the market, so this ability to
customize portfolios appeals to them."
So, what do investors need to know before jumping into the
factor-fund pool? Here are five things they should keep in
mind:
1. The strategy isn't all that new
Some may refer to smart beta as a recent innovation, and many
investors think that is what they are getting. In reality,
quantitative investing, or using data to create a portfolio with a
particular kind of tilt in an effort to outperform the market or
reduce risk and/or volatility, dates back about half a century.
What is new is that a strategy once employed mainly by
institutional investors is now available to the masses, thanks to
technology and a wider range of market data that allowed fund firms
to create new investing models using quantitative tools and package
them in products with low fees.
So while the first ETFs carrying the moniker of smart beta made
their debut in 2003, the investing approach employed by these funds
has a longer history than many investors realize.
Peter Lazaroff, chief investment officer of Plancorp, a St.
Louis advisory firm that manages $4.2 billion for high-net-worth
families, says his firm has been using quant products since the
mid-1990s. "But what has changed a lot in the last few years is
that the number of offerings has multiplied, and in the last two or
three years we've really seen the costs go down."
How fast have these funds multiplied? According to Morningstar,
there are now more than 700 strategic-beta ETFs, up from 364 in
2014.
2. They aren't as 'passive' as you might think
Advocates like to emphasize the characteristics that make
factor-based funds close cousins to index funds, but investors
shouldn't be fooled into thinking that is what they are. These
products are more complicated.
Sure, fees on factor-based funds generally are lower than on
traditional actively managed portfolios, and most factor-based
funds track some kind of index. But those indexes are unique,
constructed specifically for the fund by people who made a series
of decisions, based on their reading of the data, on which
securities should and shouldn't be included. As such, smart-beta
funds, like actively managed investments, can look and behave very
differently, depending on who created the index's rules and on the
analytical approach or assumptions that individual or group
used.
Say an investor wants a smart-beta fund focused on high-value
stocks. Well, each fund might have a different perspective on the
best way to capture value, and even a different view of what a
value stock is. One might pick the 100 stocks in the S&P 500
with the lowest price/earnings ratio and most consistent quality;
another might emphasize price-to-book ratio (which compares a
firm's market value to its book value) and low volatility.
"Anytime you have some kind of active decision being made, by a
human manager or in executing on a formula," the investment
strategy becomes less precise than what an investor may suppose,
says Patrick Huey, principal adviser at Victory Independent
Planning, based in Portland, Ore.
As for costs, expense ratios on strategic-beta ETFs average
about 0.17%, according to a Morningstar report from last year,
which is generally higher than the typical passive investment tied
to a cap-weighted index like the S&P 500 but significantly
lower than an actively managed mutual fund. Still, the overall cost
of a factor-based fund can end up being more than investors
realize. That's because factor-based funds tend to buy and sell
securities more frequently than the typical index fund, leading to
higher trading costs.
3. Look past a fund's name to its construction and
methodology
A lot of factor-based funds have similar names. But they can be
very different for the reasons described above. As such, smart
investors will do their homework to understand exactly what they
are getting.
Ken Nuttall of New York-based BlackDiamond Wealth Management
says even he has been caught off-guard by products that sound
similar but in fact offer dissimilar strategies and returns.
"I only just realized there is a difference between a
low-volatility fund and a minimal-volatility fund," he says. The
former involves creating a portfolio of those stocks in S&P 500
with the lowest volatility. Minimal volatility, he explains, means
creating a portfolio of stocks that, when combined, are
characterized by lower volatility, even though some individual
holdings in that portfolio might have very volatile stock charts
when viewed in isolation.
In today's competitive marketplace, fund firms should be able to
give a quick summary of how their product differs from its peers in
terms of construction and methodology. If that isn't clear in the
prospectus, or in other investor communications such as quarterly
reports, well, that's a red flag.
Among other things, the fund firm should make clear how often
the fund rebalances its holdings -- which can drive up expenses --
and whether there is a provision that might allow a manager to
override the rules that govern the fund's operation most of the
time -- which could turn the fund into something the investor
wasn't expecting.
That said, investors should be wary of any marketing materials
that might suggest the funds are more customized than they are.
While factor-based strategies allow investors to home in on
securities with certain characteristics, the funds aren't
customized portfolios.
"Treat these funds the same way you would an active fund,"
cautions Alex Bryan, director of the passive research strategies
team at Morningstar. "You really have to look under the hood."
4. Any factor can stop generating healthy returns for a long
time
The argument in favor of factor-based investing is that
long-term research shows that over full market cycles adopting
certain tilts in a portfolio improves the chance that it will
outperform a broad market index.
The reality? Regardless of what historical data say, any single
factor can be out of favor for a long time, leading an investor to
wonder whether they are doing the right thing. (Just ask die-hard
fans of value investing how they feel about the current bull
market, driven higher by growth stocks and often by momentum.) And
sometimes factors that are supposed to deliver completely different
return patterns (say, value and momentum) end up behaving in
roughly the same way. Look no further than the 2008 financial
crisis, when most asset classes fell in tandem.
Investor psychology is crucial.
"Be prepared to stick with your strategy for at least a full
market cycle to capture the benefits of what you're trying to do,
and be honest with yourself about your tolerance for tracking error
relative to the index," counsels Mr. Huey.
Advisers often underestimate a client's willingness to follow an
idea that loses money on a relative basis year after year, even if
history tells them it will work out eventually, adds Mr.
Lazaroff.
5. Yes, these funds can be strategic core holdings -- if used
appropriately
Now that individual investors can access factor-based investing
strategies through tax-efficient ETFs, there is every reason to at
least consider using one or two of these funds as a strategic
long-term investment, assuming the fund's strategy makes sense and
it provides adequate liquidity (meaning it is easy to buy and sell
shares without affecting the asset's price).
The key for investors is to understand what they are hoping to
accomplish by investing in a fund with a particular tilt instead of
a more traditional one, and how the product fits in with the other
investments in their portfolios.
"Understand that owning a minimal-volatility fund because you're
worried that the market will crash will still leave you with a lot
of exposure" to stocks, says Mr. Nuttall.
Ms. McGee is a writer in New England. She can be reached at
reports@wsj.com.
(END) Dow Jones Newswires
December 08, 2019 22:27 ET (03:27 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.
Apple (NASDAQ:AAPL)
Historical Stock Chart
From Aug 2024 to Sep 2024
Apple (NASDAQ:AAPL)
Historical Stock Chart
From Sep 2023 to Sep 2024