By Chris Mellor
The active versus passive debate has vexed UK institutional investors for many years. Until relatively recently, it seemed investors had just two choices. However, the debate has taken on a new dimension with the advent of smart beta1 Exchange Traded Funds (ETFs).
A smart beta ETF uses an automated, rules-based investment process, instead of employing active management via a team of analysts and a portfolio manager, and so the fees on these products are generally lower than for active funds. However, smart beta ETFs take a different approach to market-cap-weighted index (i.e. “beta”) investing, as they use filters and characteristics other than just market capitalisation to select and weight each of the underlying securities. Many of these smart beta strategies aim to outperform the market, just as an actively managed fund would.
Smart beta still accounts for a small minority of the ETF universe, but it is currently the fastest-growing segment and has attracted growing interest, including in the UK. As such, Citigate Dewe Rogerson (CDR), on behalf of Source, conducted research2 among institutional investors to assess their thoughts on this exciting and fast-growing segment of the asset management market.
The results revealed a surprisingly high adoption given smart beta’s relatively recent entry to the market. Just over a quarter (27%) of the institutional investors surveyed said they currently invest in one or more smart beta strategies and, of those that do not, 31% anticipate they will do so over the next two years.
Moreover, 64% of institutional investors believe assets in smart beta funds will grow between now and 2019 (only 4% think it will decline, with the remainder undecided), and 34% anticipate assets under management in these strategies will increase by 30% or more. 28% of institutional investors believe that the key reason for this anticipated growth will be that investors are likely to increasingly focus on smart beta strategies to enhance the dividends they receive.
Given that smart beta products shift the focus away from pure market cap weightings, the tendency is towards a more value style of investing. As such, smart beta can – and we believe will – play a growing role in helping investors find quality stocks that pay an attractive dividend. In recent years, there has been growing emphasis placed on income/dividends because of low interest rates and expectations of a low growth environment.
Dividends are certainly harder to come by, too: CDR research3 also showed that 61% of institutional investors anticipate that dividends from UK companies will stay the same or decline this year when compared to 2015; 64% of institutional investors anticipate this about dividends from European stocks, and 52% predict this for US equities.
Given smart beta is relatively new, do institutions have any concerns about it? Do they anticipate new regulations will be required as the sector develops rapidly? Over half (57%) of institutional investors anticipate that a growing number of ETFs using smart beta strategies will be launched between now and 2019. However, care needs to be taken when it comes to selecting these: some commentators argue that the term “smart beta” is being misused and 26% of the institutional investors we surveyed expected tighter rules to be introduced around what constitutes this term.
Recent years have seen an explosion in the range of ETFs offering smart beta exposure. Investors can now choose not only individual country and sector products but those with exposure tilted towards specific factors such as value, momentum or quality (or combinations of these), fundamentally weighted indices, risk-controlled indices and dividend-focused indices. The key decision for institutional investors though is to decide how a particular smart beta product might fit within their portfolios. Namely, does it (a) provide tactical exposure to a specific market characteristic or (b) use a more complex set of rules with the aim of outperforming traditional broad beta exposure? Once that key question is answered, we believe investors can use smart beta ETFs most effectively.
Chris Mellor is executive director of equities product management at Source
