In 2013, two product trends in the ETF space dominated the press: smart beta and actively managed ETFs.

Both of these innovative approaches are designed to compete with index funds as well as actively managed mutual funds. These investment vehicles are meant to provide asset managers and their advisor clients with differentiated products and strategies with enhanced returns. While these products have proven successful in attracting assets and have performed well, they have shown some limitations - opening the door for the next wave of product innovation to meet asset managers' investment needs. Mutual fund and ETF providers require an investment vehicle that deploys a strategy akin to actively managed funds, while still maintaining the core benefits offered by ETFs. By combining the best traits of smart beta and actively managed ETFs, a solution may be on the horizon. By staying on top of these product trends, managers can more effectively gather and retain assets by differentiating themselves in a crowded market and bolster distribution efforts.

Smart Beta and Actively Managed ETFs Attract Assets

Smart beta has a proven track record of success with the Guggenheim S&P 500 Equal Weight ETF (RSP), the PowerShares FTSE RAFI U.S. 1000 (PRF) and the First Trust Capital Strength ETF (FTCS), based on the Nasdaq U.S. Benchmark Index. Although their styles vary, these smart beta approaches share a common goal of attracting investors who do not want to merely accept average returns through vehicles like the SPDR S&P 500 (SPY).

Actively managed ETFs also proved to be a success, attracting about $15 billion of the roughly $1.65 trillion ETF market. These have succeeded in gathering assets despite the logistical problems for their managers due to the daily disclosure requirements of the underlying holdings. If the reporting and methodology requirements are not relaxed, ETF managers who employ actively managed strategies, or would like to do so, will remain fearful of hedge funds and other opportunistic traders gaming their strategies.

Enhanced Alpha ETFs Satisfy Managers' Needs

In 2014, enhanced alpha ETFs make an entrance. These strategies will also address one of the most sensitive issues with both RIAs and wealth managers, and their clients who are invested in ETFs: transparency.

While actively managed ETFs struggle with the issue of transparency of holdings, enhanced alpha ETFs will be employed in vehicles where rebalancing cannot be readily gamed by interested parties, but constituent transparency will not be an issue. Constituent transparency will not be an issue because there will likely be periodic rebalancing or reconstitution rather than the daily rebalancing which is typical in actively managed ETFs. A second concern that enhanced alpha ETFs address is the desire for liquidity. While hedge funds offer enhanced alpha strategies, lock ups and opaque investment styles are no longer appealing to high net worth investors and their advisors. Thus there is a large demand for vehicles offering enhanced returns while providing both transparency and liquidity. We anticipate both ETF providers and creators of separately managed accounts will introduce enhanced alpha products to satisfy that need.

Dimensional Fund Advisors introduced a stock's profitability into their investment process in an effort to add growth stock vehicles to its existing suite of Index products. Dimensional's products were all Index vehicles until 2013, and weren't geared toward growth stock investing. In order to offer growth vehicles to the advisor community, they had to add company profitability factors to differentiate the promising growth candidates from the laggards.

In the ETF arena, two early examples of successful vehicles include the Shareholder Yield (SYLD) ETF launched by Cambria Funds, and the PowerShares DWA Technical Leaders Portfolio (PDP).

What's New on the Horizon

The coming months will see new indexes and ETFs based on multi-factor models which seek to provide enhanced alpha by narrowing existing indexes down to their most promising constituents. The willingness of index creators to provide transparency into the factors employed will broaden the market for these next iteration of actively managed ETFs. The ability to overlay proven quantitative models on top of existing indexes which reflect investment styles, market capitalizations or generally embraced investment themes such as low price to book value, shareholder yield, corporate buy back and earnings growth, will be a growing force in the ETF and SMA world. For those innovative firms that find a way to add alpha while safeguarding against daily rebalancing and reporting, there exists a mutually beneficial opportunity for both investors, index creators and asset management firms. A year from now the headlines may not be about smart beta but rather about the growth of enhanced alpha investment vehicles.

Marc Chaikin is CEO and founder of Chaikin Analytics, a provider of stock research and analytics to asset managers and wealth advisors.

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