Smart beta exchange-traded fund strategies reached the institutional investing forefront in 2013 when the Arizona State Retirement System revealed its backing of four new ETFs from BlackRock Inc.'s iShares unit.
Those four funds, each seeded with roughly $100 million from the Phoenix-based fund, hold $4.8 billion, with the $32 billion ASRS reporting at least $575 million of that amount, based on regulatory filings.
While it's not uncommon for large investors to seed ETF launches, the Arizona train hasn't been the “all aboard” call that some in the institutional market thought it would be for smart beta ETFs. But it's fitting that roughly three years out, smart beta strategies are now working their way into the financial tools used by pension funds and others for transitions, liquidity, rebalancing and tactical shifts, similar to the uses employed for market-cap weighted ETFs and other index-based financial instruments.
How these institutions view smart beta might be a surprise.
According to a recent survey by FTSE Russell, a division of London Stock Exchange Group, 35% of asset owners view smart beta as part of their active equity allocation, up from 22% in 2015. Of those who have adopted smart beta, 47% use at least three strategies.
The size of an asset owner's holdings also affects their vehicle preference, with only 18% of funds of less than $1 billion saying they prefer ETFs. Funds of more than $10 billion use separate accounts and internal management.
While early debates on quantitative investing strategies that seek to isolate, or combine, specific risk factors were hung up on terminology — “Does that mean market-cap weighting is dumb beta?” — proponents and opponents have since coalesced around “smart beta” to generally indicate indexed strategies that look to capture enhanced returns or risk reduction afforded by isolating factors such as value, quality, momentum and low volatility.
“Active managers essentially screen their holdings based on many of these factors,” said Ken O'Keeffe, global head of ETFs at FTSE Russell in New York. “So when clients look to use smart beta for exposure to factors, they prefer to use smart beta indexes based on their existing benchmarks for comparability.”
According to the FTSE Russell survey, 46% of asset owners now considering smart beta are looking at multifactor strategies. That coincides with asset managers' recent ETF product development, which has focused on multifactor approaches across size, sector and geography.
As of June 30, 444 unlevered “smart beta” equity ETFs in the U.S. market held $236 billion in assets, according to research firm XTF Inc., New York. Dividend-focused and low- or minimum-volatility ETFs are among the largest funds.
Over the last three years, these funds have drawn $75 billion in net flows, or 33% of current assets, compared with traditional market-cap weighted products, whose three-year flows account for 22% of current assets.
Not an industry conference goes by without a panel debate on the efficacy of the strategies, including last month's IMN Global Indexing and ETFs conference featuring a plenary titled “How Smart is Smart Beta?” While the panel itself didn't include asset owners, some investors have concluded, “smart enough.”
Erik Carleton, director of pensions investments for Textron Inc. in Providence, R.I., said recent portfolio manager turnover in its active equity portfolio offered Textron the chance to create a separate account that is three-quarters iShares Edge MSCI USA Value and one-quarter iShares Edge MSCI USA Quality.
While the exposure is only about 0.5% of Textron's public equity portfolio, the customized factor mix using ETFs offered “more targeted portfolio risk control” during a transition and helped “set up the pipes, paperwork and process” for greater use of ETFs, Mr. Carleton said. For broader reallocations, he said he opts for the less expensive, more liquid futures market, but sees smart beta ETFs offering “a greater ability to shape a beta exposure,” without the expense of customization.
Ajit Singh takes an even broader approach to smart beta. As chief investment officer of the $3.7 billion Houston Firefighters Relief and Retirement Fund, he views the strategies and ETFs as a more defined way to manage risk.
“Herding in broad-based indexes pushes some holdings to be overvalued,” said Mr. Singh, “and many traditional active managers essentially invest based on the relative value of particular factors.”
Mr. Singh prefers a multifactor ETF that equal weights value, size, momentum and quality, but had to run that product through the same manager search process and proposal to the investment committee as he would any other active or passive exposure. Ultimately, he said he believes that opportunity to control drawdown presented by tactical implementation of factors also allows for significant cost control relative to hedge funds. n