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Ben Johnson

Factor ETFs: Investors should tread carefully

22-03-2016 | Insight While at Robeco we strongly believe in the benefits of taking a highly active approach to factor investing, there’s no denying that passive factor strategies are growing in popularity among many investors.

There’s a lot that we can learn from what’s going on in other markets, so we spoke to Ben Johnson, director of global ETF research at Morningstar, to find out his views on the main developments in the factor exchanged-traded fund (ETF) market.

How is the factor ETF market developing?
“Quite simply, strategic-beta ETFs are exploding in popularity, and are growing faster than the broader ETF market as well as the asset management industry as a whole. Their growth has been driven by new inflows, new launches, and the entrance of new players – some of which are traditional active managers. This has led to an increasingly crowded marketplace.”

“We expect these trends to continue and possibly accelerate as newer ETFs tracking unproven benchmarks mature and more new entrants make their way to the market. But this process of growth and maturation will ultimately lead to a culling of the herd, which has already begun in some regions, albeit to a limited extent. To put some figures on the size of the market, as of the end of June last year, there were 844 strategic-beta ETFs, and they held a total of USD 497 billion of assets.”

Which factors are currently the most popular?
“Dividend-based strategies remain by the far the most popular segment in Europe, accounting for over 50% of total strategic-beta ETF assets. Their continued popularity can be attributed to the attractiveness of income in the current low-rate environment.”

“Meanwhile, low-volatility or minimum variance strategies increased their share of the strategic-beta ETF universe from 8% to 13% in the year to last June. Investors’ increased focus on risk in the face of continued economic uncertainty has helped ensure it remains the second-most popular strategy. Elsewhere, quality strategies have increased in popularity and now account for 5% of the total strategic beta ETF market in Europe.”

What other trends are you seeing in the market?
“One of the most obvious developments is that new ETFs are following increasingly complex benchmarks. This is part of the natural evolution of the market and one that has already played out in the development of traditional market capitalization-weighted portfolios along the lines of region, country, sector, subsector, and so on.”

“A downside of this is that as these strategies become increasingly nuanced, incorporating elements of active management into an index, the amount of due diligence that investors have to undertake will increase commensurately.”

Are investors taking up these increasingly complex products?
“Not hugely so. While complexity has been on the rise, investors still seem to prefer the simpler strategies. Classifying the current US strategic-beta ETF market according to its secondary attributes shows that ETFs offering exposure to fairly straightforward strategies (value, growth, dividends) account for 70% of strategic-beta ETF assets. That said, multi-factor ETFs increased their share from 6% to 11% in the year to the end of June.”

What are the implications of all the new entrants to the market?
“An increasingly crowded and competitive landscape will put pressure on fees. In recent years, we have witnessed something of a price war unfold in the European ETF market, with providers slashing charges on their core offerings in an attempt to attract inflows. The razor-thin profit margins on these highly commodified vanilla exposures have prompted providers to turn to strategic beta as a means of differentiating their product offerings.”

‘An increasingly crowded and competitive landscape will put pressure on fees’

“The fall in the combined average weighted fee from 0.44% to 0.39% for all European strategic-beta ETFs over the past year clearly shows the impact of increased competition.”

What kind of due diligence does selecting an ETF involve?
“The most important consideration in my view is cost, and this is one thing that investors can control – if a product is too expensive, don’t buy it. Many asset managers are rolling out strategic-beta ETFs to justify higher fees and to distract investors from this fundamental principle.”

“As is the case with selecting active managers, the next thing investors must assess is whether these products are following a sensible strategy. Most strategic-beta ETFs’ underlying benchmarks exploit one or more factors, so the sensibility of the strategy depends on the viability of the factors it looks to harness. There have been hundreds of factors ‘discovered’ by academics and practitioners over the years, but most are the result of data mining and have no basis in sound economic theory.”

“Third, not all factor exposures are created equal. Marginal differences in index-construction methodologies can yield significant differences in performance amongst similarly labeled strategies. It’s important to understand how efficiently these funds’ underlying benchmarks are capturing their targeted factors and whether they might be missing the mark by virtue of being costly to implement or loading up on other, unintended exposures.”

“The fourth thing to consider is capacity. The persistence of any factor is reliant on there being someone on the other side of the table willing to take the opposite side of your factor bet. In order for Value to produce excess returns, there must be other investors shunning Value. If everyone were to simultaneously bet on Value, it would ultimately become the ‘market’. So it’s important to understand the capacity of factor strategies in much the same way it’s important to understand the capacity of an active strategy. Where is there capacity? Generally speaking, look for the foundational factors (Value and Momentum) in the broad, deep developed markets.”

“Last, but certainly not least, it’s important to partner with a capable, responsible sponsor: Morningstar research has shown that good stewards of shareholders’ capital have tended to produce better long-term investor outcomes.”

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