Finding a new investment angle with Smart Beta ETFs

In a recent paper entitled ‘The Smart Beta ETF (r) evolution’, Amundi suggests that origins of smart beta ETFs lies in the aftermath of the global financial crisis. At the time investors were concerned about the inherent volatility of the equity markets, a problem that was amplified by the introduction of ultra-low monetary policies that sent liabilities ballooning.

“Investors faced a tough conundrum,” the paper says. “Their funding gaps had risen, which required a more aggressive investment strategy but, at the same time, over-allocating to risky assets like equities was ill advised. High volatility and steep market corrections could create losses they could ill afford.”

The perfect solution for many investors, and a perfect entry point for smart beta was the evolution of low volatility equities, Amundi says. Here investors could still access equity markets, but with less risk than conventional strategies, and with the low costs that come with investing in ETFs.

This strategy works well during periods of economic contraction, which can often translate into market corrections and increases in volatility. But, Amundi notes, it will usually underperform in a bull market which could be accompanied by increases in interest rates.

Low volatility strategies got investors familiar with the concept of using smart beta. As they became more comfortable with this investment concept and, as economic growth recovered and equity markets started to perform well, they realised there was a broader universe available.

According to Nicolas Fragneau, head of Amundi’s ETF product specialist team, users of Smart Beta ETFs are still largely professionals who appreciate the low cost, transparent and liquid nature of ETFs.

“Quite honestly largely educated investors use these products,” Fragneau says. “It takes a bit of knowledge to understand exactly how they will perform against the market as they are more complex than your regular index.”

The use of Smart Beta ETFs varies greatly from one investor to another. This is why Amundi has chosen to offer two very distinct ranges within their smart beta offering so that they can meet the needs of all their clients. The first are the single factor ETFs. Here Amundi offers ETFs for each of the major factors in a portfolio, including factors such as value, low volatility or quality. 

“Those ETFs are for investors who want to make their own factor allocations, maybe play one factor against another depending on the environment,” he says. “They allow you to create a portfolio depending on your view, giving you full control over the factor allocation process.”

Nicolas explains that the second smart beta range at Amundi is the multi factor range. “Here the idea is that factor timing can be complicated, and building your own model using several factors, and weighing them in a manner that can outperform the market over the long term can be difficult.”

For those investors who would prefer a combination of factors within one product, the multi factor range offers a solution.

“One route is to build up your own allocation and have all the tools for implementing your changes in your view, and the other is to buy and hold a single product that aims to outperform in the long run, simply by spreading your exposure across factors” Fragneau says.

Amundi offers eight single factor ETFs, which cover mainly Europe but also the US, while multi factor products are available for Europe, the US and world.

“The idea of multi factor products is that they offer an alternative to core positions. Therefore, if you own some European or US ETF exposures, you can switch into a multi factor in an effort to out-perform the market. This is why our multifactor range mirrors the vanilla index exposures,” Fragneau says.

The latest ETF launch from Amundi was the single factor ETF on US minimum volatility, the only US factor ETF, whereas in the European range, they have all the factors covered. A new launch might be within the US range, depending on how that product does, Fragneau says.

“I think smart beta is an important part of the ETF offering,” he says. “It’s an essential part of any allocation as there is a place for factors and in the last decade factor investing has become as important as your country allocation or your sector allocation within your portfolios.”

Fragneau comments that if you buy a country or geographical region ETF, you also need to look at the sectors in the markets. “Some are more dividend or tech orientated,” he says. “Factors have truly become the equivalent of sectors or countries when you build your allocation.

“What’s important here is that they give you another angle to the market, another way to allocate and try and outperform the market. Smart beta ETFs are added value in the tool box of any investor.”

The development of smart beta now allows investors to tailor their portfolios through ETFs, Amundi says. They can split stock characteristics into two broad groups: those which have defensive characteristics and those which have cyclical attributes. 

Like low volatility, the ‘dividend’ and ‘quality’ factor shares tend to perform well when the economy is contracting. They are defensive attributes. Dividend factors select those stocks which can deliver a sustainable high income, a characteristic that has been popular as investors have sought alternative sources of yield in a low interest rate environment.

The ‘quality’ factor emphasises those companies with lower debt and higher profit margins than the market average. Most importantly, these firms are capable of comfortably generating regular cash flows. These corporates provide a measure of protection during a period of rising interest rates because they have few liabilities on their balance sheet.

When economies start to recover and financial markets rise, these defensive factors will tend to underperform the broader market and those with cyclical characteristics will perform better. 

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