There are now over 2,000 U.S.-listed exchange traded funds with about $3 trillion in assets under management. Contributing to this rapid growth, a new breed of smart beta or factor-based index ETFs has quickly hit the scene.
Supporting the continued growth of smart beta ETFs, large institutional investors have taken a bite of the new strategies as a way to potentially enhance returns or diminish risk in their portfolios.
The share of institutional ETF users investing in smart bet ETFs increased to 37% in 2016 from 31% in 2015 according to Greenwich Associates. In 2016, 41% of asset managers invested in these smart beta funds, and half of investment consultants said their clients used them.
What exactly are smart beta ETFs? Smart beta ETFs are investments that are exposed to factors, Andrew Ang, Head of BlackRock’s Factor Based Strategies Group, said in a research note. These factors are historically persistent drives of returns within and across various asset classes, and strategies with targeted factors can be allocated alongside traditional investment portfolio positions to potentially improve a portfolio’s outcome.
“Given the impact factors historically have had on performance, we believe factor strategies will become mainstream portfolio holdings in the future,” Ang said.
For instance, the equity style factors of value, momentum, quality and small size have historically outperformed over the long haul. Value refers to those securities that are underpriced relative to fundamentals. Momentum refers to securities with upward trending prices. Quality refers to companies with solid balance sheets and less volatile earnings. Lastly, small size includes a tilt toward smaller or small capitalization companies. Additionally, the volatility factor that favors those with historically lower risk has also been used to help diminish risk in a portfolio.
ETF investors can access individual factor-based, smart beta strategies or through ETFs that combine several factors, called multi-factor strategies.
“Single factor strategies can be used strategically to increase diversification or tactically to take advantage of economic cycles where certain style factors perform better than others,” Ang said. “The style factors value, momentum, quality and size have exhibited low correlated returns, so they can also provide diversified exposure when they are combined in multifactor strategies. Over the long term, combining these factors may produce even more consistent results over time than any individual factor strategy.”