Though ETF growth has been extraordinary in recent years, there are still impediments to more explosive growth, at least for now. Major issues include educational hurdles (“What are ETFs?” “How are they traded?”), the inability to use them in 401k/defined-contribution plans, and the inability of distributors to identify or compensate fund flows. Another significant reason is the reluctance of many gatekeepers of institutional portfolios (pensions, endowments, foundations, etc.) to use ETFs. This may be due to insufficient expertise or, more likely, the difficulty of showing a clear analytical value-add by drawing significant contrasts between competing ETF products. This is key. The ability to compare and contrast differences in actively managed mutual funds or separate accounts has been an important service of investment consultants. This, however, is another opportunity for smart beta ETFs – and ETF strategists – to lead the charge for continued, outsized ETF growth.
ETF strategists will be able to help investment consultants and gatekeepers understand and contrast different ETFs. It isn’t just about comparing costs. It’s about digging deeper into the underlying factor strategies and indices, understanding how different factors interact with each other, and understanding that factors, like all investment strategies, have a rhythm and cycle to their performance. Factors work over time, but not all the time. Understanding when and where factors perform is important to knowing how to use them.
Factor-based indices, even in the same category, can have significant differences in risk and return characteristics. There are a variety of possible reasons for this: investment universe, factor definition, weighting scheme, rebalancing frequency, underlying costs, and many more. Since performance differences can be significant, due diligence is critical.
Bottom line: factor-based analysis and smart beta investments will become increasingly important in the years ahead. Better understanding can produce better investment results. And better investment results will produce better asset growth. ETF strategists who can educate consultants on factor-based investing and provide analysis, recommendations, and portfolios based on factors will open new doors and opportunities to help more investors.
Rusty Vanneman is the Chief Investment Officer at CLS Investments, a participant in the ETF Strategist Channel.