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Advisor ETFs Growth in ‘smart beta’ ETFs appears to be slowing

The growth of so-called ‘smart beta’ ETFs has been slowing.

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Strategic beta exchange-traded funds (ETFs) have been a hot trend for investors looking for an alternative way to play the ETF market.

Also known as “smart beta,” these funds use different index construction rules than the more traditional market-weighted approach by applying specific screens to a list of securities, such as value, dividends or low-volatility.

The strategic beta market has grown more quickly than the broader ETF market over the past decade, according to Morningstar Inc. It has been driven by new players, new products and new money coming into the market.

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But its growth appears to be slowing. Morningstar data show the number of new strategic beta product launches dropped to 132 in 2018, down from a record 257 in 2017.

Ben Johnson, director of global ETF research at Morningstar, says it’s a sign the strategic beta market is maturing and becoming more saturated: “The waterfront has been covered.”

Price competition is expected to put further pressure on these ETFs, which often have higher fees than traditional index-weighted ETFs because they require more active management. Providers across all ETF segments are feeling pressure to lower their fees, which in turn provides less incentive to launch new strategic beta funds at lower margins.

Some ETF providers are also reducing fees for their strategic beta products given the “increasingly crowded landscape where investors are having a difficult time differentiating between seemingly similar strategies,” Mr. Johnson says.

And while strategic beta funds have been popular, they represent a small portion of the overall market. There were 1,493 strategic beta ETFs worldwide as of Dec. 31, 2018, according to Morningstar, with collective assets under management (AUM) of approximately US$797-billion. That compares to an overall ETF market of US$4.76-trillion in AUM globally as of Dec. 31, 2018, and 7,584 ETFs.

In Canada, assets invested in strategic beta funds have grown to $10.1-billion as of year-end 2018 from $365-million a decade earlier. The number of funds has surged to 182 from nine during the same 10-year period. Still, strategic beta funds represent only about 8.8 per cent of the total Canadian ETF market by AUM, Morningstar data show.

Strategic beta funds are held back in part by investor and advisor confusion about them, according to a recent report from the global research firm Cerulli Associates Inc.

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“The increasing expertise required to understand the products, and key discrepancies in how they are positioned, hinder product use,” the report states. It includes a survey that shows only 21 per cent of financial advisors report using strategic beta products, “a smaller portion than would be expected given the wide availability and product development focus.”

The survey also says 71 per cent of advisors don’t know whether the strategies are meant to outperform the market.

The confusion may be due in part to a lack of education as well as the way some providers promote their products, says Kevin Gopaul, global head of ETFs at BMO Global Asset Management. About 40 per cent of BMO’s ETF lineup is smart beta funds.

Mr. Gopaul, who is also president of the Canadian ETF Association, believes more issuers need to do a better job of educating investors on how to implement smart beta strategies in their portfolios.

“I don’t think there’s a lot of confidence in how smart beta strategies, in general, can be used in portfolio construction,” says Mr. Gopaul, adding that his company has put additional resources into product education. “People have to know how to use them.”

He also believes some products were improperly positioned as being able to outperform their peers. “They shouldn’t be predicated on the notion of outperformance. They should be marketed as another tool to manage the exposure you want in your portfolio,” says Mr. Gopaul.

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‘Smart beta’ ETFs are more volatile because they focus on a particular strategy instead of the overall market, says Deborah Frame, president of Frame Global Asset Management.

Deborah Frame, president and portfolio manager at Toronto-based Frame Global Asset Management, says strategic beta ETFs are likely losing steam in part because their higher cost, given their active-management element, eats into returns.

The funds are also more volatile because they focus on a particular strategy, instead of the overall market. “For the most part, people want to avoid the uncertainty,” says Ms. Frame, who invests in ETFs on behalf of her clients, but not in strategic beta ETFs.

What’s more, Ms. Frame cites data showing actively managed funds haven’t outperformed the market, including during the period of volatility in 2018.

A recent SPIVA scorecard generated by S&P Dow Jones Indices shows that more than 75 per cent of active Canadian mutual funds failed to beat equity benchmarks in 2018.

“This highlights the fact that heightened market volatility does not necessarily lead to outperformance by active managers,” the SPIVA report states. The report also says that nine out of 10 Canadian equity funds fell short of their benchmark over a 10-year period.

“Only a minority of portfolio managers are able to generate superior investment returns over benchmarks,” says Ms. Frame. “Smart beta strategies have not generally been outperforming strategies.”

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