Slideshow What's the state of the strategic beta market?

  • December 05 2017, 9:58am EST
12 Images Total

Smart, strategic, factor-based — whatever you call them, these ETFs are on course to post another windfall year, winning over institutional and retail investors alike. But that hasn’t silenced critics.

“There’s a whole class of investors that have grown increasingly fee conscious but are not willing to settle for the broader market,” says Ben Johnson, director of global ETF research at Morningstar. Strategic beta ETPs are filling the void for advisors with clients who want an active allocation without paying high fees.

The global strategic beta ETP market has skyrocketed in recent years. So far in 2017, assets have grown 18% to $818 billion, according to data from Morningstar Direct.

Competition has led to lower fees and forced strategic funds to distinguish themselves from cheaper traditional ETFs. Elisabeth Kashner, director of ETF research at FactSet, compares today’s strategic fund to “an independent bookseller trying to compete with Amazon.”

While strategic beta may be the cool new kid on the block, so-called vanilla index funds are still favored by ETF investors, with 72% of total assets. Strategic beta funds have a 22% share of the ETF market. Within strategic funds, investors favor approaches that target growth, value and dividends.

Click through the images above for more insights on the state of the strategic beta market.

Strategic beta assets have been climbing a trillion-dollar hill

Strategic beta ETPs continue to attract large inflows, building on years of rapid growth. In 2017, total AUM for the industry passed the $700 billion mark — only to top $800 billion later on.

But that success comes with problems for new entrants. As with the overall ETF market, the strategic space has become crowded, and fee competition is intense. “As an issuer, you are compelled to do something different,” says FactSet’s Kashner.

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Competition drives fees down

“The ETF marketplace in general is highly competitive and really quite saturated,” says Kashner. The same is true for strategic beta ETPs, and cost pressures are mounting: fees have come down 22 basis points in the past three years.

“The same degree of fee pressure that you see in the bulk beta space has been spilling over into the strategic space,” says Morningstar’s Johnson.

The U.S. appetite for strategic beta dwarfs all other markets

The U.S. has the most developed market for factor-based ETPs. That’s to be expected, says Kashner, since the U.S. is home to two-thirds of assets in the overall ETF market.

Also, U.S.-based ETFs benefit from foreign investors, says Johnson. He estimates that 20-30 cents of every dollar invested in U.S. ETFs comes from abroad.

European and Canadian markets are growing quickly

Both Europe and Canada have posted strong year-over-year growth, but these figures can be a bit misleading, says Johnson. “Those two markets are growing off of a relatively smaller base,” he says. “The law of small numbers is certainly part of what you’re seeing there.”

The move toward fee-based advisory models in Europe and Canada may also be a factor, he adds, as brokers have less incentive to push costlier products that pay them a commission.

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Investors prefer time-tested investment strategies

Investors have put the lion’s share of assets into strategies centered on value, growth and dividends. Kashner argues that tradition is a factor here. Dividend strategies have been around for as long as people have been living off of their portfolios, she says, and value strategies go back to Benjamin Graham.

BlackRock and Vanguard funds lead the pack

BlackRock and Vanguard have used their scale and ETF expertise to dominate the strategic beta market, according to Johnson. “They have the ability to price their funds extremely competitively,” he says.

Institutions say they use strategic ETPs for four main reasons

Investors surveyed by FTSE Russell chose strategic ETPs based primarily on four criteria: Less risk, better returns, diversification and lower costs. While the merits of strategic assets may be debated when compared with vanilla peers, these funds can offer significant cost advantages over active management, says Johnson.

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Nearly half of institutional investors own strategic beta

Institutional investors have moved more quickly than retail investors when it comes to buying strategic beta assets — 46% now have at least some allocation, according to FTSE Russell.

Factor allocations are expected to continue growing

Both institutional and retail investors plan to increase their allocation of strategic beta assets over the next five years, according to Invesco.

In ETF war, plain-vanilla funds claim victory

Despite the range of new exchange-traded options, investors have a clear preference: cheap, diversified and straightforward. “The vanilla space is the big gorilla, and investors are really truly paying attention to it,” says Kashner.

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Strategic beta approaches to bonds are also largely unexplored

Despite the frenzy of excitement for strategic funds in the equity space, issuers and investors don’t have the same appetite for a bond equivalent. While some equity factors also exist in the bond market, Johnson argues that they can be exploited with vanilla funds. “Credit and duration are the two big ones,” he says.

Another component, Kashner says, is the overall lack of time-tested options. “These are relatively newer products,” she says.