This article first appeared in The Edge Malaysia Weekly on September 10, 2018 - September 16, 2018

Exchange-traded funds (ETFs) have attracted their fair share of criticisms, including allegations that they push up the valuations of certain stocks with no regard for their fundamentals. On the back of these concerns, multi-factor smart-beta ETFs have gained in popularity as they combine both passive and active strategies to avoid some of the risks associated with regular ETFs.

According to London-based research and consultancy firm ETFGI, assets invested in smart-beta ETFs and exchange-traded products (ETPs) reached a record US$696 billion as at end-January. Multi-factor smart-beta products saw the largest net inflows, followed by smart-beta ETPs that only use the value factor. ETPs include products such as exchange-traded notes.

Multi-factor smart-beta ETFs can be an alternative for investors seeking better risk-adjusted returns from their passive investments, says Chandra Seethamraju, senior vice-president and head of smart beta and overlay strategies at Franklin SystematiQ, the quantitative hub of Franklin Templeton Multi-Asset Solutions.

“Most investors have a passive benchmark as a component of their portfolio. If you can get a better return with lower risk than the benchmark that you are now holding, it seems to be a no-brainer that you should be holding a smart-beta portfolio,” he adds.

“As you are targeting certain factors, the mix of those factors gives you protection from the downside so you do not lose as much. And when you do not lose as much, you are already winning.

“There is growing interest in smart-beta strategies. We are at a point right now where a lot of institutional investors in Asia are actively considering these strategies.”

Instead of tracking market-capitalisation-weighted indices, multi-factor smart-beta ETFs track those that have been constructed using specific rules. These rules take into account factors such as the quality, value, momentum and volatility level of the stocks.

The smart-beta strategies — active stock-picking based on specific rules — are not only applied by ETF providers but also used in the construction of mutual fund portfolios. For example, in Franklin Templeton’s separately managed institutional account, it uses a multi-factor strategy of 40% quality, 40% value, 10% momentum and 10% low volatility. The allocation was determined to reach its objective of getting a better risk-adjusted return in the long run with less volatility than the benchmark.

“There are many dials that you can shift around to get different outcomes. These are the building blocks. If an investor wants higher beta, it can be achieved with the same building blocks put together in a different portfolio construction,” says Chandra.

“Not all smart-beta strategies are the same. So, the key is to do some due diligence to look at the strategies, at how they are differentiated, at the outcome expected to be achieved. Match those with what you are looking for and then enter that strategy.”

Different providers, important factors

There is diversity in multi-factor smart-beta ETFs as the weightage given to each factor could differ from one provider to another. Some ETFs focus on low volatility as their core exposure, for instance. There are also strategies that give equal weightage to all factors.

“Franklin’s approach is more rooted in our 60 years of experience in stock-picking from a more fundamental perspective. We think about the type of stock that a fundamental analyst would prefer. [Probably] something that is cheap and has a strong balance sheet that will enable the stock to come back to its fair value,” says Chandra.

“We use the same philosophy here. Quality and value are two of the most important components of what we do. So, most of the weightage in strategies are allocated to these two.”

Some of the measures used to identify quality include return on equity, debt-to-equity and net income.

Low volatility and momentum are more affected by share price movements, Chandra observes. It is more difficult to benefit from those factors. Thus, tracking low volatility and momentum involves a lot of turnover in the portfolio, which translates to additional costs. “We use these factors because they have some impact. But there is much less emphasis on them,” he says.

Multi-factor smart-beta strategies can filter out stocks that are overvalued and protect investors during a market downturn through careful stock selection. However, during a bull market, it may not give investors the same types of returns as ETFs that track market-capitalisation-weighted indices.

“In a period of rising markets, which has been the case in the last two or three years, almost everything is driven by momentum and this type of strategy is likely to underperform the market capitalisation-weighted benchmarks,” says Chandra.

“For instance, in the last 1½ years, emerging markets could give you a return of 40%. But a factor-based strategy will not give you 40%, it will lag. However, when you start getting volatility, like you have in the last few months, these strategies hold up much better as they have an inbuilt protection when the markets go down.”

Multi-factor smart-beta ETFs do not have the same risks as their single-factor counterparts because a single factor cannot perform well under all market conditions. For example, according to Franklin Templeton’s August 2017 paper on smart beta, stocks that demonstrate low volatility were the top performers among the different factors in the last two quarters of 2014. However, they became the worst performers by the second quarter of 2015.

“Most of the providers that enter the marketplace now have a multi-factor approach and we agree with that because if you pick a single factor, you have to be very good at timing that factor. Otherwise, you can have severe drawdowns that will impact your portfolio,” says Chandra.

“From an investing standpoint, multi-factor strategies make sense. But what is key is that people need to understand the methodology. Value to one provider could be quite different to another provider.”

Some providers have a higher beta in their strategies as well, which means the constructed index will be more sensitive to market movements.

Chandra observes that multi-factor smart-beta ETFs can outperform regular ETFs by 2% to 4% over a 7 to 10-year business cycle. However, that performance comes with a higher price as smart-beta ETFs can be more expensive than those that track a market-capitalisation-weighted index, although that gap is narrowing.

“Smart-beta ETFs are a bit more expensive than passive ETFs. But if you look at the magnitude of our performance, at how much the smart beta beats the market-capitalisation-weighted benchmark, it more than pays for the [extra] fees associated with smart-beta ETFs. I think it is justified because there is alpha there, meaning you are getting outperformance,” says Chandra.

Many of the popular ETFs still track single factors. According to ETFdb.com, which tracks US-listed ETFs, smart-beta ETFs with the most assets under management as at June 7 were the iShares Russell 1000 Growth ETF, Vanguard Value ETF and iShares Russell 1000 Value ETF. The fees imposed by the three funds range from 0.05% to 0.20% while their year-to-date returns range from -0.33% to

9.45%.

Will multi-factor ETFs cause the next crash?

Last year, Bank of America Merrill Lynch’s global research department warned that the massive popularity of ETFs may lead to a market liquidity problem. With a huge amount of money flowing into ETFs, it could cause the market to fluctuate violently due to any single event. But there are also opposing views that such liquidity issues could be caused by other investing vehicles as well while different types of ETFs pose different risks.

Chandra Seethamraju, senior vice-president and head of smart beta and overlay strategies at Franklin SystematiQ, says there are not enough assets in the multi-factor smart-beta ETF space for this to be a problem yet. “It will take a while before the assets in multi-factor ETFs get to a level where it becomes an issue. I don’t think we will see it over the next few years. The asset base has to grow really large for it to have an impact,” he adds.

“But at some point, there could be a clouding of factors, where everybody is following the same factors and the alpha for that goes away. The problem is mitigated by the fact that each provider has a slightly different variation. So, it is not all the same definition. But just because something underperforms does not mean it is overcrowded.”

He says the ETFs that tracked the volatility index (VIX) and crashed earlier this year was a unique case. In February, the VelocityShares Daily Inverse VIX Short-Term ETN plunged more than 80% in a single day and was liquidated.

Its impact cannot be extrapolated to other ETFs because it was tracking a derivative instead of an index, says Chandra. “That is a very specific type of ETF, which lost value for a very different reason. The VIX is a technical indicator, but multi-factor smart-beta ETFs are much more fundamentally based on the attributes of a company.

“Does it have strong quality? Does it have value? When you are holding these stocks, it is much less likely to have any of the issues associated with the VIX-based products.”

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.