When people began driving cars, all processes involved were manual. Starting the engine, rolling down the window, and changing gears were all in the hands of the driver. Over time, these processes have become automated, but the driver remains in control of the vehicle. Asset management has developed in a similar way. Active managers leverage new technologies and automation to improve their decision-making processes, trade execution, and performance attribution, but maintain control of the vehicle.

Technology enhancements continue to change the way we consume information and produce new tools to make informed decisions. The challenge for future development is striking the appropriate balance of responsibility between driver and machine. In asset management, there are fundamental questions about leaving the responsibility of investment management to an algorithm, particularly during periods of extreme volatility.

Exchange traded funds (ETFs) have emerged as a popular investment vehicle with retail and institutional investors and a major disruptor to asset management. Assets in ETFs, and other exchange traded products (ETPs), currently comprise 8% of global fund assets, up from 2% ten years ago.1  After making significant gains, largely in passive management, ETFs are also expanding into a broad array of strategies described as smart beta or strategic beta. Morningstar recorded that ETFs following these strategies worldwide brought in $68 billion in 2016, raising assets under management 18.7% to $625 billion. More recently, net inflows to smart beta have spiked significantly, registering a 2,000% year-over-year gain in the first three months of 2017. Though the name smart beta suggests these investment strategies are passive, it is more accurate to view them as a hybrid of passive and active approaches to managing investments. At a fundamental level, sponsors of smart beta are seeking a combination of returns and risk that are superior to traditional beta products.

SMART BETA TRENDS

An emphasis on lower management costs, which has benefited passive strategies and competitively priced actively-managed products, have worked to smart beta’s advantage. Smart beta expense ratios remain more competitive than their actively managed peers,3  but the gap is closing. Data from Morningstar shows that average expense ratios fell between 2006 and 2016 for smart beta ETFs at a quarter of the largest 20 ETF providers in the US. However, the data also shows expense ratios increased for smart beta ETFs at more than half of the companies due to the launching of more complex products, and sustained by pricing that remains competitive with similar actively-managed products.4  Expectations for further expense ratio reductions in 2018 appear to be accelerating in line with pricing pressure across the industry. Given investor appetite for lower priced products, we can expect fees to trend downward over time.

USAGE

According to BBH’s 2017 US ETF Investor Survey with ETF.com, 97.5% of US financial advisors and institutional investors responding stated they planned to maintain or add to their smart beta positions in 2017.5  Equally important from an investor’s perspective, our survey demonstrated that demand for smart beta is broadly mixed between investors seeking a replacement for passive strategies only, and investors seeking to replace a purely active strategy.6  More on this to come.

The 2017 Cerulli report on US ETFs highlighted a number of findings on the development of the market. Over the next two years, advisors expect to decrease their allocation to index ETFs by 5.4% and increase their allocation to smart beta ETFs by 4.4%. Advisors also expect their ETF allocations in smart beta to increase from 17% to 22% over the same timeframe. As for usage, the overall adoption of factor-based investing continues to proliferate, signaling a move from using smart beta to provide marginal exposure to becoming a core component of the overall portfolio.

WORLDWIDE ADOPTION

As of June 30, 2017, there were 1,320 smart beta ETPs, with collective assets under management of approximately $707 billion worldwide.7  BBH worked with seven clients to launch 19 different smart beta ETFs in 2017.

United States

In the first half of 2017, smart beta ETFs in the US grew to a record $621 billion. In 2016, a 27% annual increase exceeded a 16.6% increase in assets across all US domiciled ETFs. Estimated 12-month net inflows of $69 billion in 2016, however, were slightly lower as a percentage of assets when compared to net inflows of $288 billion for all US ETFs. Smart beta ETF inflows for the 12 months to June 30, 2017 comprised 14.2% of assets, versus 11.3% for all US ETFs.

Europe

While starting from a smaller base than the US, smart beta ETFs in Europe grew 38% over the same period to $56.2 billion.8  Also, it is significant to note the increasing share of overall ETF net sales in smart beta products. By mid-2017, smart beta ETFs accounted for 8.1% of Europe’s total ETF assets, up from 7.6% in mid-2016.

Asia Pacific

Smart beta products experienced significant growth in the Asia Pacific region, notably in Japan where smart beta AUM of $12.5 billion comprises almost three-quarters of the region’s total. Australia is the second-largest market with smart beta AUM of $2.2bn, followed by South Korea ($969m) and China ($414m). While Japan’s 12-month smart beta AUM growth of 65% is impressive given its share of the regional total, AUM growth was greatest in Singapore (180%) and Malaysia (151%), albeit from a smaller asset base. Overall, assets under management in Asia Pacific grew by more than 57% between June 2016 and June 2017.9

Exchange_Thoughts_Global_ETF_Growth

Exchange_Thoughts_Strategic_Beta_ETPS

SPONSORS AND ADVISORS

As smart beta continues to generate attention, there seems to be a misalignment between ETF issuers and advisors. Findings from the 2017 Cerulli report showed that more than 65% of ETF issuers are positioning smart beta as a replacement for passive ETFs, however nearly two-thirds of advisors are using it to replace active mutual funds. This disconnect is not only specific to how these strategies are marketed; the same report showed similar findings in terms of how smart beta is used. Advisors cite risk management as a main reason to use smart beta, while issuers point to outperformance. More than 60% of issuers are positioning smart beta to generate alpha, whereas the most-cited reason by advisors for using smart beta is for downside protection. Product development is another area where issuers and advisors do not currently align. Although multi-factor products have been dubbed as the next evolution in smart beta, less than 50% of US advisors say they are using them. This mixed messaging presents both a challenge and an opportunity for smart beta products. Neither side is wrong in their thinking due to the versatility of smart beta, but asset managers should be sure investors aren’t letting any confusion stunt their interest.

FIXED INCOME DEVELOPMENTS

Currently, most smart beta assets are concentrated in US domiciled equity-based ETFs, but as the adoption of smart beta continues to rise, so too will the opportunity for its application to fixed income and other asset classes. While the risk profile is different (in equity markets, risk is stock-specific; in fixed income, the main concerns are interest rate and credit risk) and there is generally less volatility in terms of price movement, there are still opportunities around credit and duration which provide interested parties a set of tools to contend with the inefficiencies associated with a market cap-weighted approach. Depending on what label one assigns to smart beta, the rise in fixed income may have already begun. If the definition is anything that uses a nonmarket value weighted index, there is a wide range of fixed income products that would qualify as smart beta. As the June issue of ETF Report explains, “the ‘invisibility’ of smart beta bond ETFs may work to the issuer’s advantage since investors traditionally have looked to fixed income for safety and stability whereas smart beta has come to suggest a level of riskiness”.10  As the interest rate environment changes and the market for equity-based products matures, it will be interesting to track the growth of the smart beta fixed income products.

ROOM FOR ACTIVE MANAGERS

In 2017, we saw another year of impressive smart beta flows, driven primarily by the interest in the opportunity for alpha generation in a structure that is low cost, transparent and tax efficient. But you should not let this cast doubt on the future of active fund managers. The due diligence process for creating the investment strategy looks and feels very familiar for the active manager who has traditionally used factor investing as a predictive indicator.

Despite the beta label, smart beta should not be viewed solely as a transition to passive management. Instead, it is as an additional entry point for talented managers to display their skill in another product wrapper. As the market for smart beta evolves with new product development and geographic expansion, it presents active managers with opportunities to leverage their expertise, educate investors on the salient advantages of their strategies, and prove their value at a competitive cost.

THE WAY FORWARD FOR SMART BETA

We are still in an early period of smart beta growth and should expect both the number of products available and the methods of deploying these strategies across geographies to grow. As we move forward, it will become increasingly difficult to provide a differentiated offering as the field becomes more crowded and the continued momentum of fee compression impacts the assets gathered in these products.

Like the ETF industry, growth in smart beta will largely depend on education. Sponsors of smart beta products will need to align with advisors on how to present the benefits of these products, as well as how to deploy them. As the product continues to grow, so too will the methods of evaluation. We are now seeing 3 to 5-year track records come into play, allowing advisors and investors a method to benchmark performance. Over time, we will also be able to see how these strategies perform in different market cycles, adding to the back-tested data used to determine the effectiveness of a given strategy. We will also see how multi-factor strategies perform and whether they justify the complexity and added fees.

Compliance Notes
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority. BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2017. All rights reserved. 12/2017 IS-03505-2017-12-04

Sources: ICI Data, Statista, BBH analysis
2  2,000% rise in new money allocated to smart-beta funds, Financial Times, May 14, 2017
3  2017 Morningstar report: A Global Guide to Strategic-Beta Exchange-Traded Products
4  “Signs that smart beta price war has started,” Financial Times, February 4, 2017
5  ETF Survey – Brown Brothers Harriman.” BBH, 1 Dec. 2017, www.bbh.com/etf-survey
6  Russell Indexes Global Smart Beta Survey, December 2014
7  2017 Morningstar report: A Global Guide to Strategic-Beta Exchange-Traded Products
8  2017 Morningstar report: A Global Guide to Strategic-Beta Exchange-Traded Products
9   http://www.international-adviser.com/news/1038022/smart-beta-assets-57
10  ETF report June 2017 – Smart Beta Bond ETFs Hiding in Plain Sight