Bolstered by still-low interest rates and increasing consumer confidence, U.S. markets may continue to rise in one of the longest bull markets in history. Many financial advisors, however, are preparing for a time when the economic outlook isn’t as promising. After analyzing what went wrong leading into the 2008 financial crisis, advisors are seeking to build better diversified client portfolios than before the crisis.
This is increasingly leading investors to examine factor-based investment solutions and smart beta exchange-traded funds. Although the academic concepts behind these strategies aren’t new, packaging these concepts in investable ETFs is new. Many advisors are still learning how smart beta and factor ETFs are constructed. In addition, there is a need for more education on how best to blend them into client portfolios, and to explain the additional diversification benefits they may provide.
As a refresher, beta is a representation of a security or portfolio’s volatility relative to the market as a whole. Smart beta takes the concept of beta a step further by offering specialized indices based on distinct factors that build on the existing style-box concept. Every asset class is seen to carry elements—or factors—of risk and return, such as volatility, momentum, size, value and quality.
Common to all asset classes, these broad underlying factors may contribute to returns, help protect against risk, or both. Given the expanding universe of factor-based ETFs, advisors today have very few limits when choosing single or multi-factor as building blocks for an investment solution.
The Rise Of Factor Investing And Smart Beta Strategies
Advisors are looking beyond the classic asset-allocation models of diversification. In 2007-2008, many portfolios previously thought to be diversified with a mix of equities, bonds, and alternatives were exposed as unintentionally risky and highly correlated, meaning they moved in lockstep with the market and in similar patterns to one another. In the years since the financial crisis, investors seeking greater security have poured money into index funds. But according to a global survey of institutional investors from Natixis, 75 percent fear that individual investors are not aware of the risks of indexing.
They can develop a false sense of security about indexing since traditional stock market indices can be disproportionately weighted toward larger companies and sectors.
With a goal of further diversifying client portfolios, advisors are increasingly choosing factor-based smart beta strategies. In fact, these strategies are now outpacing the broader market both in terms of assets and number of products, with a three-year compound annual growth rate (CAGR) of 46 percent compared to 17 percent CAGR in equity ETFs. Total assets invested in single-factor ETFs are expected to pass $400 billion by 2022, but the solutions have not yet reached their full potential due to a lack of education.
For instance, when asked about their use of smart beta investment products, only 35 percent of advisors in a recent FTSE Russell study reported having used them when descriptive examples were not included. Yet when prompted by specific product names, 68 percent identified themselves as users. As advisors continue to educate themselves about factors and factor-based products, however, they are increasingly recommending them to their clients. Assets under management of equity factor ETFs have increased from $6.7 billion in 2006 to $78.0 billion in 2016.
We may see greater growth in factor-based strategies in 2017 if market volatility begins to pick up following seven years of mostly uninterrupted economic growth.