The number of strategic beta exchange-traded funds on the market has grown substantially over the past few years, but these complex offerings aren’t always what they seem.
Asset managers have been eager to establish a foothold in this hot investment area, and advisors need to be mindful of what they’re buying, warned Patrick O’Shaughnessy, principal and portfolio manager at O’Shaughnessy Asset Management, speaking at the Morningstar Investment Conference in Chicago on Thursday.
“You need to ask, what is this strategy designed to do? Gather assets or produce real alpha, net of expenses,” said O’Shaughnessy. “That question is important. What is the motivation if, say, Goldman Sachs is launching a [fund]? Is it a land grab? That’s Wall Street. Be mindful of cost. Not all smart beta ETFs are bad. Some are good.”
Strategic beta strategies are designed to work over many years, rather than being a flavor-of-the-month investment. These strategies usually focus on investments using the factors of value, low volatility, quality and momentum.
However, with the interest in the theme high, some funds are claiming to be something they’re not, said Wes Gray, the founder, CEO and CIO of Alpha Architect.
He said sometimes there’s a significant difference between what a fund is called and what it actually does. For instance, Gray said, a value fund may say it’s based on the factor investing research of Eugene Fama and Kenneth French, yet there might be nothing in the portfolio construction showing it’s based on academic evidence.
Both Gray and O’Shaughnessy said such funds are chasing hot money, which is another reason advisors need to be careful. Short-term money isn’t going to be interested in something like value investing because not only does it mean buying unloved stocks, but also lagging the broader markets. And an investor who is chasing a hot investment doesn’t want to buy a fund that’s lagging.
In other words, O’Shaughnessy, holding value has to “hurt.”
A lot of ETFs creators who say their products are strategic beta are trying to promote the products as passive investments because they’re rules-based, but Gray said investors shouldn’t believe these are truly passive vehicles.
“The best point about factor investing is it is active investing,” he said. “To say it’s not is lying to yourself. So you need to do the same level of due diligence.”