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Can smart beta ETFs and active management coexist?

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Spencer Betts has always been an active management guy. He didn’t like benchmark-hugging ETFs because passive products hold the bad companies with the good. If a big player on the S&P 500 were to go south and drag down the index, then the ETF would fall in tandem. Stock picking, he said, made more sense.

About two years ago, Betts started hearing about smart beta products — ETFs that implement investment strategies like value, momentum and high yield, and are designed to beat the benchmark. His stance on passive investments began to soften.

“ETFs have gotten more interesting,” says the Lexington, Massachusetts-based adviser with Bickling Financial Services. “We used to have ‘Dogs of the Dow’ mutual fund, but now we can get an ETF and pay 20 basis points instead of 65.”

About 10% of his firm’s $200 million in assets under management are in smart beta ETFs, but he says he could see a more even split between active management and ETFs in the future.

“ETFs have gotten more interesting. We used to have Dogs of the Dow mutual fund, but now we can get an ETF and pay 20 basis points instead of 65" – Spencer Betts

Until recently, the choice between ETFs and active management was clear. Advisers who wanted to hold inexpensive index-like products would buy ETFs, while those who preferred stock-picking managers would buy mutual funds.

With the advent of benchmark-beating ETFs, the lines between active and passive have blurred. That has advisers wondering what’s better for their clients – smart beta securities or actively managed funds?

If you look at the data, factor-based investing does exceed its benchmark more often than mutual funds. According to ETF Trends, between December 2013 and April 2017, only 19% of active managers outperformed their respective style benchmarks compared with 40% of smart beta ETFs.

In other research from Bloomberg, Peter Lynch’s Fidelity Magellan fund was pitted against a quantitative value strategy that invested in the cheapest 30% of U.S. stocks by price-to-book ratio and weighted them equally across the fund. Between May 1977 and May 1990, the years Lynch managed his fund, the Magellan portfolio returned 29.1% annually with 21.1% standard deviation. The smart beta strategy returned 23% annually with a 17% standard deviation.

One problem with much of the smart beta data is that many of these funds have only been created recently, so historical data is sparse. The lack of a track record is why Betts isn’t more heavily invested in these products. There are back-tested numbers, but “every back test shows that this is the best investment ever,” he says.

Still, these funds have taken off — assets under management rose 33% to $560 billion in globally listed smart beta products in February — largely because they come cheap. For instance, the most popular smart beta fund by AUM, the iShares Russell 1000 Value ETF, has a 0.2% expense ratio. The largest value-focused mutual fund, American Funds Washington Mutual, has an expense ratio of 0.58%.

“Cost the is the primary factor,” Jacob Wolkowitz, managing director of Minneapolis-based Accredited Investors Wealth Management, says. “If you want a stock picker who is valuation conscious and can pay 0.09% for that versus 0.25%, then why wouldn’t you go with the cheaper option? You can get the same returns or better from factor investing, but at a lower cost.”

Despite the fee gap — ETFs’ tax-efficient structure also gives it an advantage over mutual funds — many advisers continue to embrace active management, including Wolkowitz, whose firm has about 20% of its assets in smart beta strategies, 25% in more traditional passive ETFs and the rest in actively managed funds.

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His company, which oversees $1.7 billion from high-net-worth clients, started using smart beta strategies in 2006 and has replaced most of its U.S.-focused mutual funds with factor ETFs. Its international investments are overseen by fund managers.

In the United States, active managers do not add as much value, he says, noting that most have only been able to generate minuscule or even negative excess returns.

“These are active bets employed in a passive rules-based systematic fashion. Once the playbook has been written, no one’s going to call an audible” – Ben Johnson

Wolkowitz points out his unfamiliarity with international markets and the fact that many of the products do not yet have a track record. With that, he says he would rather entrust his client’s assets to real people.

“We have a better understanding of corporate governance in the U.S. and we know that what’s worked in the past is likely to work in the future,” he says. “Emerging markets are still figuring things out and value companies may not recover as consistently as they have in the U.S.”

Ben Johnson, Morningstar’s director of global ETF research says most advisers do use a combination of smart beta and active management, in part because smart beta ETFs cannot adjust their asset allocation in a pinch like fund managers can.

“These are active bets employed in a passive rules-based systematic fashion,” he says. “Once the playbook has been written, no one’s going to call an audible.”

Every adviser also has a different style. One might use a manager with a strong track record and only uses smart beta to fill in some gaps. Others, like Wolkowitz, might want to use managers in areas in which the adviser is less comfortable.

“There can be a case that these investments can be used together and that’s the reality of what we’re seeing,” Johnson says. “If you look at the makeup of a client’s portfolio, they’re using all things active, passive and everything in between.”

That’s Betts’ approach. He might be an ETF convert, but he still likes his active managers.

“I’m happy with the active beta stuff because I agree with it. But they complement each other. We believe in long-term asset allocation so we just want to have the clients in the right buckets over time.”

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