Smart beta funds could be moved to endangered list

Could the ringing in of 2019 be the death knell for many smart beta exchange-traded funds? If so, few industry participants would be surprised after academic research on isolating factors and fundamentals to capture risk premiums swelled into a product hype machine.

"A term that has no definition is meaningless and only serves to confuse and obscure the true innovations of the ETF ecosystem," wrote Michael Venuto, chief investment officer of Toroso Investments, in an August newsletter tracking ETF developments.

But recent debt and equity market volatility, coupled with ongoing operating challenges in the asset management industry, might just give those issuers offering smart beta ETFs the clarity to refocus and hone their messages.

The term, originally coined to market strategies that attempt to isolate investment factors such as value, momentum, quality and minimum volatility, has expanded to include dividend-weighting and the combination of several factors into one product. Early proponents of smart beta and factor-weighting included Research Affiliates LLC and Dimensional Fund Advisors LP. But as ETFs increased in popularity and utility for traditional indexing, more asset managers began to flood the zone with factor-based offerings extending to sectors and regions.

According to FactSet Research Systems, of 877 factor-based ETFs launched since 2000, 72% have been launched in the past seven years. Yet the bulk of the $682 billion in assets in factor-based ETFs remain with those launched in the early 2000s largely based upon traditional market-cap weighting and growth and value splits, as well as various dividend screens.

"The pace of new strategic, or smart beta, ETF launches is way down in the last three years," said Elisabeth Kashner, vice president, director of ETF research and analytics for FactSet in San Francisco. "It's mostly over. Just look at asset level per fund."

Only 34 ETFs launched since 2011 have gathered $1 billion in assets, compared to 64 launched prior. Among the exceptions are broad-based low and minimum volatility offerings from BlackRock Inc. and Invesco, as well as several single factor-based products that BlackRock initially launched with assets from the Arizona State Retirement System in 2013.

Still, it appears some issuers are clearing out shelf space where the smart beta ambitions stretched too thin. In August, BlackRock closed a handful of minimum volatility and multifactor ETFs, both designations that fall under its iShares Edge brand. And in February, Invesco will shutter several smart beta ETFs, as it consolidates products following the acquisition of Guggenheim ETFs.

Even Vanguard Investments, which is often more cautious in new fund and ETF offerings, has seen limited uptake for its suite of factor-based ETFs launched in the U.S. last February.

Consider the case of the $37 million Vanguard U.S. Value Factor ETF at a 0.13% expense ratio compared to the $38 billion Vanguard Value ETF, ticker VTV, at a 0.05% expense ratio. The most recent fund is a total market fund consisting of nearly 800 stocks, whereas VTV is a large-cap value fund with 330 components. And the larger fund saw $1 billion in net flows this past month, whereas the latest launch came up with nothing.

Yet, given recent volatility, some market watchers believe that 2019 will be a transitional year for smart beta.

"Smart beta and factor investing through ETFs has been slow going, but it hasn't gone backwards," said Andy McOrmond, managing director at institutional agency brokerage firm WallachBeth Capital LLC in New York. "But when performance is down, investment committees are more open to re-evaluating their benchmarks or looking to change managers."

Mr. McOrmond said the cost of liquidity also enters into the institutional decision to take on an alternatively weighted index ETF. "It's only one factor in a holding period, including index performance and the expense ratio, but it is a risk with the smaller products," he said.

Another challenge in the smart beta marketplace is an education and messaging gap between issuers and buyers, observed Daniil Shapiro, associate director of product development at Cerulli Associates in Boston. "Our research indicates that advisers are looking for downside risk protection and ways to dampen volatility, while many issuers have been positioning these products based on their specific factor exposures and ability to generate alpha."

"Multifactor products are even more difficult to understand," Mr. Shapiro said.

Among the largest multifactor ETFs are self-indexed funds from Goldman Sachs Asset Management, J.P. Morgan Investment Management, as well as John Hancock ETFs based on indexes developed by Dimensional.