Smart Beta ETFs Are Gaining Traction Under Volatile Conditions | ETF Trends

After the abrupt sell-off last year and lingering concerns ahead, more investors are turning to smart beta ETFs tracking indexing methodologies that try to mitigate downside risks and still provide upside potential.

Smart beta ETFs attracted about $84 billion in net inflows over 2018 and could bring in over $100 billion this year, David Mann, Head of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments, said in a research note.

“I think 2019 will be the breakthrough year,” Mann said.

Mann pointed to three factors that could support the smart beta ETF outlook, including market volatility, a new ETF rule and increased awareness of passive indexing.

In the more volatile market conditions we have seen recently, many smart beta ETFs have outperformed their traditional market-cap weighted ETF counterparts.

The proposed new ETF Rule specifically acknowledged that structurally there is no difference between active and index ETFs, which could help increase ETF issuance and adoption among investors. The new rules could help make it easier for asset managers in choosing the securities they add to or subtract from an ETF when they create or redeem shares.

Additionally, Mann pointed to an academic research paper, titled “Passive in Name Only: Delegated Management and ‘Index’ Investing.” The paper argued that index investing simply represents a form of delegated management, so investors are still almost always choosing a managed portfolio. The underlying index construction methodology imply a substantial amount of delegated decision-making authority.

Smart Beta Investing Rules

“As investors realize that smart beta is simply a different set of rules than one tied to a mechanical application of market-capitalization, the allure of ‘passive’ market cap indexes should decrease,” Mann said.

Many are coming to realize that traditional market-cap weighted indexing methodologies are not without their own set of risks. Market-cap weighted indices would typically be top heavy where the largest companies have the biggest weights. Consequently, in an up trending market, investors are overexposed to the top performing company stocks, which leaves them exposed to greater downside risks in an extended bull run.

On the other hand, a rules-based or smart beta indexing methodology is seen as a way to limit these types of top heavy risks as investors are exposed to certain company fundamentals with automatic weighting rebalances over time.

For more information on alternative index-based strategies, visit our smart beta category.