Content provided by Joe Smith, CFA, Senior Market Strategist
The ETF industry continues to be a hot topic in the investment world as these flexible funds continue to show stellar growth. ETF flows for the year so far are on pace to set another record for asset-gathering activity.
So, by the numbers, what’s really behind the growth of ETFs? Here are three key charts that tell you everything you need to know.
1. ETF Asset Growth has Shifted From “Access” to “Insight” Exposures: ETFs prior to 2009 were largely focused on providing access to virtually every asset class investors could use in a portfolio. Today, new ETFs are designed to target a particular insight or investment strategy utilized by active managers, but packaged as smart beta ETFs.
2. ETF and Index Fund Net Flows Have Been Competitive Relative to Active Funds: Since 2006, ETFs and index funds have enjoyed positive net inflows. Active funds enjoyed positive flows from 2009 to 2014, but they have seen net outflows over the last two consecutive years.
3. ETF Growth is Still in Early Innings Relative to Assets: Despite the above-average growth in ETFs (especially smart beta and active ETFs), industry assets are still primarily located in active mutual funds. ETFs still have room to enjoy above-average growth until assets represent a more meaningful portion of total industry assets.
Content provided by Joe Smith, CFA, Senior Market Strategist
Smart beta ETFs continue to dominate the financial news as more investors and asset managers grapple with the continued shift from active to passive investing. Despite this movement, smart beta investing is still widely unknown, and there is little understanding about what it actually means. At CLS, we are heavy users of smart beta ETFs. We employ them primarily to gain access to return premiums, such as value, size, momentum, quality, and minimum volatility.
Smart beta ETFs aim to marry two differences between active and passive investing (fees and exposure) by screening for stocks the way an active manager would. The only difference is smart beta ETFs use rules-based methodologies to find stocks that meet an investor’s target investment exposure without the need for human judgement.
To illustrate this point, let’s take a look at the suggested holdings for both the MSCI USA Index and a hypothetical smart beta index targeting value stocks within the same index universe. The MSCI USA Index is simply a market-cap-weighted index, while our hypothetical smart beta index targets stocks that score with high exposure to the value factor.
So what do the results tell us? Not only does the smart beta index have less in common with the market-cap index in terms of the top names held in the portfolio, but the stocks clearly score much higher on the desired exposures (in this case, value) than the market-cap index. In effect, a smart beta index captures the essence of a typical active manager’s intent, but with transparent rules that re-base a traditional index along an investor’s desired exposure.
The key takeaway is smart beta investing is not necessarily new, but it’s an exciting twist to exposures investors have long accessed through active managers and their stock-picking abilities. Smart beta ETFs provide additional value for investors, including those in CLS portfolios, by providing a more cost-effective approach to accessing return premiums that deliver value for the long haul. Just one of the many reasons I love being smart beta invested!
Content provided by Rusty Vanneman, CFA, CMT, CLS Chief Investment Officer
At CLS, I like to think that – We are Unique. We are Experts. We are Nice.
As for being unique, I was able to get even more evidence supporting that from the latest Brown Brothers 2016 U.S. and European ETF Investor Survey.
Before we get to the survey data though, as we already know, the way we build balanced, diversified portfolios is unique in the industry, as we build and manage portfolios strategically by managing to target risk levels instead of targeting asset allocations. It’s a key and defining – and important – twist to building multi-asset portfolios. It allows us to actively manage the portfolios – adjusting to changing risk and return expectations – and still be able to deliver reliable and consistent portfolio behavior.
The survey, however, got across the point that the ETFs that we select are also unique for the industry. In short, our portfolio holdings look different – a lot different – than what our competitors typically buy.
First and foremost, we are an enthusiastic user of “smart beta” ETFs (iShares® Smart Beta ETFs – The Power of Factor Investing). Currently, our portfolios are nearly 50% smart beta. Less than 20% of ETF strategists have exposure even above 20%. Over 50% have 0% exposure. CLS is definitely different.
Second, actively-managed funds make up about 10% of CLS’s AUM (assets under management). The industry average is about 1%. Again, CLS is also definitely different.
Third, regarding currency-hedged ETFs (meaning we take no currency risk as everything is hedged back into U.S. dollars), our holdings in currency-hedged ETFs is currently 15-20% of our international holdings. That is above the industry average, which is below 10%. Nearly half of ETF strategists have 0% exposure.
But there’s more.
CLS is clearly unique relative to other ETF Strategists in how we select ETFs. In short, what we look for in an ETF is different. What we emphasize and what we don’t is notable.
From the same survey mentioned above, Brown Brothers surveyed investors on the seven attributes listed below. How does CLS compare? (The CLS data is taking an equal-weighted average from surveying our own Investment Team):
But first, before we get to the list, there are two variables we ALWAYS look at and emphasize first that weren’t even included in the survey:
Okay, now the Brown Brother’s survey list and how CLS differs:
Bottom line, when it comes to picking an ETF, we want to know its underlying holdings, that it tracks those holdings well, that the ETF is priced right, and that it trades well. If we find an ETF in an area of the markets that offers potentially attractive expected (not historical) risk-adjusted returns, then it’s worthy of inclusion in our portfolios.
In sum, CLS is a unique money manager – in a variety of ways.
Content provided by Case Eichenberger, CIMA, CLS Client Portfolio Manager
In 2016, every major index that CLS tracks was positive, as shown in the chart below, and outperformed cash (which is the whole reason to invest in stocks and bonds in the first place).
In the CLS Quarterly Market Outlook, we often write about what worked and what did not work for our globally diversified portfolios. In a well-diversified account, there is always something that doesn’t work. For example, in 2016 we noted that health care stocks were net negatives for investors. After a great year in 2015 (+6.84%), the popular Health Care Select Sector SPDR® ETF had a negative return on the year in 2016 (-2.76%). In the fixed-income sector, municipal bonds did not work for investors and lagged the overall bond market. Without a doubt, holding a very high allocation to these two areas of the stock and bond markets would have caused investors to second guess their choices.
Now, let’s look at this in a different way. Is there a strategy that did not work in 2016? That’s a tough question. How could any strategy lose money when all major markets moved higher? Well, it turns out, there was one: market timing or trading the headlines/news — otherwise known as being scared out of the market. At CLS, we preach staying invested at your Risk Budget and avoiding the emotional pitfalls that lead to market timing; but unfortunately, some investors end up trying to time anyway. (To be fair, a large majority of investors do avoid market timing and should be commended for keeping their emotions in check.)
Let’s take a look at two scenarios for Client X and Client Y, as illustrated in the graphic below. The first chart shows Client X and his experience/returns in 2016 at a moderate Risk Budget. He had a solid year. It started out a little rocky but ended on a very positive note. How would that experience change if the client had been at the same Risk Budget, but sold out of the market throughout the year? The pain points are shown on the Client Y chart. The first happened at the beginning of 2016 when the S&P 500 experienced one of its worst opens to the year. The client then stayed in cash until getting back in the market in early April. From there, another dramatic headline around the U.K.’s decision to leave the European Union prompted a second quick exit. Client Y stayed in cash until the end of September then got back into the market and stayed in until year end. Overall, Client Y’s market timing strategy would have performed negatively for the year.
At CLS, we hope investors can learn from these types of mistakes and stay invested, even when headlines and volatility make the market hard to stomach
Global Value Investing Had a Strong 2016
Global Value investing was one notable strategy that worked in 2016. This strategy is overweight in countries and regions that trade at discounts to their average valuations, and underweight in countries and regions that are more expensive than their average valuations. The underlying idea is that reversion to the mean will take place as the cheap areas will have strong, positive performance and the expensive areas will have weaker or even negative performance.
For dollar investors (such as the majority of those reading this blog), the returns of the 15 cheapest countries, as measured by the 12/31/15 Price to Earnings (P/E) valuation metric, returned 9.09% on average and ten out of the fifteen were positive. The biggest outlier was Brazil at 64%. By contrast, the 15 most expensive countries, as ranked by the P/E metric, returned 2.38% on average and only seven out of fifteen were positive. One of the biggest outliers was the U.S. Even with high valuations, the U.S. managed a 14% gain as other countries like Denmark, Mexico and Ireland moved lower.
Global value (a current CLS Investment Theme) won’t work every year — no investment strategy does. But it does tend to work over the long term as mean reversion takes place. So the odds are in its favor over market timers.
Content provided by Joe Smith, CFA, CLS Senior Market Strategist
Our industry continues to undergo a deep transformation that is shaking the very foundation of investing. Over the last two decades, indexing has moved from an afterthought for many investors to an increasingly dominant trend that has allowed many to access the global markets at a much cheaper price. Now, with new regulatory trends furthering the push for greater accountability and transparency, while placing increased emphasis on serving the best interests of end investors, our industry is facing a reality of lower fees, increased competition, and what many pundits are now calling the death of active management.
But is active management really dead? As a portfolio manager at CLS Investments, I don’t think so. Regardless of any one investor’s approach, the evidence has proven over time that markets are beatable. A consistent focus on valuations, identifying companies with well-run businesses, and measuring the uncertainty of one’s investments via Risk Budgeting and risk management over time can translate into better results. I believe the current trends are simply forcing a transition in the methods investors use to beat the markets — with the help of indexing and ETFs.
Wait, did I just say investors can now potentially beat the markets with indexing and ETFs? Absolutely. In fact, smart beta ETFs are leading the charge for investors to do just that. Smart beta ETFs are different because they bring the best of both worlds together to formulate an investment portfolio. In many cases, smart beta ETFs are responsible for replicating commonly followed investment strategies most active managers have been adhering to for decades. The only difference is a smart beta ETF’s main role is to translate what used to be a manager’s unique and expensive alpha into more transparent and affordable beta.
So what do you get when you put all of these thought-provoking ideas together? In my honest opinion, it’s a revolution. A revolution for many investors to reclaim what appears to have been lost in the decades-old objectives of professional money managers: to consistently deliver modest performance that can help investors meet their long-term goals. The only difference is being active can now mean being passive too, while utilizing the power of indexing and smart beta ETFs. Smart beta ETFs represent the essence of active management merged with the long-term benefits of transparent, lower-cost, rules-based indexing. Welcome to the new era of active management.
Content provided by Grant Engelbart, CFA, CAIA, CLS Portfolio Manager
We are three quarters down in 2016, and we can definitively say that smart beta is here to stay — in CLS portfolios and the industry as a whole. At CLS, our X-Factor theme, which is based on our use of smart beta ETFs, has been extensively covered in direct commentary from CLS and through various media outlets, such as ETF Trends’ ETF Strategist Channel. That being said, it’s worth heading back to square one and take a look at the investment trend taking the industry by storm.
First, let’s dissect the term smart beta. Not to be confusing, but we’ll start with beta. Beta is technically a statistical measure showing the degree of co-movement with the market. For instance, a beta of 1.5 implies a security should capture 1.5 times the return of a benchmark and 1.5 times the risk. It works similarly to our Risk Budget score (in fact, it’s a key component).
With beta comes alpha, which is the amount of excess performance when adjusting for beta. Stay with me here! For example, let’s say a mutual fund has a beta of 1.5, and it returns 20% in a given year. The index it’s measured against returns only 10%. Given a beta of 1.5, we would expect the fund to return 15% (1.5 times 10% return of the index), but in fact it returned 20%. That extra 5% is alpha. Index based ETFs capture beta. The beta of SPDR S&P 500 ETF Trust (SPY) versus the S&P 500 should be right around 1. No alpha gained, just beta exposure.
Now we’ll get to smart. Below is a fake ETF based on a made up 10-stock index. Pretty simple: the weights are the same as the index. It’s delivering pure beta exposure. It’s not stupid, but for our purposes here, it’s not smart either.
So, what if we used some other information to change way the ETF is weighted? How about a factor, such as value? In that case, we drop the five stocks with the highest price-to-earnings (P/E) ratios and only hold the names with the lowest P/E ratios (most attractively valued).
Now we are starting to get smart. Our new smart beta ETF holds five stocks weighted by valuation. Our beta may be close to the market index (1), but since value is proven to work over time, we should add some alpha as well. Additional factors could be added – such as quality or momentum – and we would have ourselves a multi-factor smart beta ETF.
The end result is an ETF that doesn’t track a traditional index, since we cut off the high value names and sorted it by the most attractively valued companies, but it also doesn’t rely on a portfolio manager picking individual stocks. So it’s neither fully passive nor fully active. Many of the factors that are used to create smart beta ETFs (such as value) have proven over time to not only outperform traditional indices, but a lot of active managers. And, of course, in the ETF wrapper, investors get the benefit of much lower expenses and potential tax benefits.
The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.
Content provided by Grant Engelbart, CFA, CAIA, CLS Portfolio Manager
We are often asked about our ability to add value to a portfolio of American Funds. After all, American Funds are the largest actively-managed fund company in the United States for a reason – they are darn good. There are over 60 different American funds to choose from (some are fund-of-funds), and each has its own unique characteristics. These unique allocation differences can lead to large return differences within the American funds lineup, even within specific categories of funds. It may be quite surprising, but on average since 1990, there has been a 10% annual return difference between different American funds, regardless of asset class.
Below highlights this observation. Within each of these five categories we show the average difference between the returns of the highest and lowest fund. This may be very surprising to even some avid users of American funds – there is an average 14% annual difference between the returns of different U.S. Equity American funds over time! By only owning a couple of American funds, you may find yourself on the opposite end of this spread in certain years.
So, what can be done about this dispersion? First is to diversify your American funds holdings. Even this year we have seen some of the top performing funds from 2015 be the bottom performers this year (and vice versa). Spreading out your holdings across the American Funds lineup gives access to more asset classes, managers, and management styles. Trying to predict which funds will outperform year in and year out is a daunting (if not impossible) task, but by using a disciplined process of analyzing valuations across asset classes and styles we can allocate to funds that provide the best opportunities going forward for outperformance given their mandates.
Content provided by Joe Smith, CFA – CLS Senior Market Strategist
Smart beta ETFs continue to be a popular topic in the investment industry. They’ve created excitement because they follow indexes that intentionally deviate from a market-cap-weighted index and have deep roots in academic and institutional investment circles. This provides opportunities for additional risk management and return enhancement without having to significantly deviate from strategic long-term allocation policies with tactical investing.
So, how do you know if you are really getting what you pay for? At CLS, we take a very methodical approach to evaluating smart beta ETFs. This process looks similar to what an institutional investor would expect from an investment consultant when performing due diligence on an active manager.
1. Smart Index Selection Criteria
A rules-based index methodology is at the heart of every smart beta ETF. The methodology takes a well-known actively managed investment process and streamlines it into a set of decision criteria that can capture the majority of that investment process without divulging into nuanced security selection. Efficient smart beta ETFs have index methodologies whose rules are clear cut and repeatable over time without the need for human judgement.
2. Intelligent Combination of Factor Exposures
All smart beta ETFs result in an investment strategy that captures exposure to one or more factors common in investing, such as value, size, momentum, minimum volatility, quality, and/or dividend yield. An important consideration is how effective the smart beta ETF is in combining these factors to pare out unwanted risk and target the desired investment characteristics associated with the original strategy.
3. Balanced Weighting and Rebalancing Process
The final step in bringing any smart beta ETF to life is determining the portfolio weight of the underlying securities that made it through the rigorous selection process and how frequently the weightings should be refreshed. Both steps are critical to the stability and performance of any smart beta ETF. In any case, a good smart beta ETF should be designed to intelligently trade off the weighting approach and rebalancing cycle to ensure that risk, return, and trading costs remain balanced through time.
As more smart beta ETFs come online it will be critical for investors to have a consistent way to evaluate and identify the differences between each product. Not all smart beta ETFs are created equal, and being able to identify which ones are appropriate for portfolio selection can add value for investors over the long term. At CLS, we continue to focus on dissecting and understanding the smart beta ETF landscape in order to do just that.