ETF Trends
ETF Trends

By John Lunt, President of Lunt Capital Management, Inc.

The Morningstar ETF Conference was the center of the ETF Universe in early September.  The conference highlighted ETF industry growth and impressive sophistication of ETF products and solutions. At the conference, I had the opportunity to participate on a panel titled “Getting Active with Factors.” Our moderator, Alex Bryan from Morningstar, did a masterful job stimulating thoughtful discussion about the Smart Beta ETF landscape and about the characteristics of popular factor strategies. I was privileged to join Anthony Davidow from Charles Schwab, Thomas Martin from GLOBALT, and Rob Nestor from BlackRock iShares. Each panelist brought a unique perspective to the discussion, and I gained several valuable insights from listening to my fellow panelists.

The terms “Smart Beta” or “Alternative Beta” are commonly used but not necessarily commonly understood. When investors refer to “Market Beta,” we simply understand it to reference the market capitalization-weighted return or exposure of a particular asset class.  Therefore, “Smart” or “Alternative” Beta simply includes any index methodology or weighting strategy that is different from a market-capitalization approach. The term “Smart Beta” is unfair, as it implies a market-cap beta is “dumb.” Instead, we frame the discussion as pure market exposure (as represented by a market cap weighting approach) and the introduction of strategy exposure (as represented by a set of rules that include, exclude, or weight the asset class components differently than their market weight). In our opinion, many Smart Beta strategies are thoughtful and warrant consideration. However, investors need to recognize that Smart Beta does not eliminate all types of risk.  Instead, the risk has simply changed form from market risk to strategy risk.

SEE MORE: ETF Investors: The Real Action is Beneath the Surface

Many indexes and ETFs with a factor focus are powerful tools that allow investors to express specific views. Academic and industry research points to the potential benefits of factors such as value, low volatility, high quality, and momentum (the definitions and combination of factors are varied and extensive). We embrace the growing library of research that argues for the use of factors within investor portfolios. Importantly, we recognize each factor will have seasons of outperformance and seasons of underperformance relative to each other and relative to the market-cap weighted benchmark. The potential for differences in performance and for high tracking error are desirable—this opens the potential for outperformance. Factors go in and out of season, and in our view, these transitions provide tremendous opportunity for factor rotation.

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