Glut of smart-beta ETFs is pushing issuers toward bonds

The explosion of “smart-beta” exchange-traded funds last year was the latest gold rush to hit the fast-growing $3 trillion ETF industry.

But as investors gather in New York City Wednesday and Thursday for a conference focused on smart-beta ETFs, fund issuers find themselves facing a few emerging realities.

First, there are only so many ways to mine these shiny strategies that now total more than $745 billion in assets and promise to outsmart the market by building indexes around themes, called factors, such as momentum or value. Second, very few that do it actually strike it rich. And third, if you want to differentiate yourself, you probably should focus on bonds rather than stocks, which are more tapped out.

“There’s clearly a lot of clutter,” said Bloomberg Intelligence analyst Eric Balchunas.

While assets continue to pour into factor-based strategies, the issuance of new equity portfolios has screeched to a halt. In 2017, there were 100 new smart-beta ETFs, while in the first half of 2018 the number shrank to 20, according to Bloomberg data. And that includes products that provide exposure to a single factor, like stocks exhibiting low volatility, or indexes tracking firms that fall into a category known as ESG for their focus on environmental, social and governance issues.

Why is this happening? Because while there are many options available, investors are crowding into a few products that hold the bulk of the assets in their respective categories. For example, when it comes to dividend strategies there are 95 funds, but just two of them — the Vanguard Dividend Appreciation ETF and the Vanguard High Dividend Yield ETF — account for almost one-third of the combined assets.

Cost Savings

One tried-and-true method for attracting assets to smart-beta strategies is to compete on price, according to Rolf Agather, managing director for North America research at FTSE Russell. In the firm’s fifth annual global institutional smart-beta survey, 31% of respondents said cost played a role in their evaluations, more than doubling the share who said that in 2014.

“The real story here is that, in the early days, smart beta was a replacement for traditional passive products by doing something beyond traditional market capitalization,” he said. “Smart beta is now increasingly being used as an alternative for active management since they’ve become cheaper than active strategies.”

Another finding in the FTSE Russell survey is that multifactor combinations have become the most commonly adopted strategy among institutional investors, who are increasingly comfortable with single-factor products.

“We didn’t even include [multifactor] as a choice in the first year,” Mr. Agather said. “What we’re seeing now is clients are moving toward not just trying one particular factor, or even buying individual factors and then trying to combine them. They’re actually looking to buy those all in one product.”

‘Chicken and Egg’

While issuers continue to launch splashy marketing campaigns for single-factor funds and are busy trying to find the next big multifactor idea, most of them agree that the next frontier for smart beta can be summed up in a single word: bonds.

“This is almost a chicken-and-egg scenario,” Mr. Agather said. “In the fixed-income space there just isn’t a lot of product, so naturally you don’t see a lot of demand.”

Big ETF managers, like Invesco’s PowerShares unit, see debt funds as ripe with opportunity. The firm’s recent acquisition of Guggenheim Investments’ $39 billion of ETFs not only made Invesco the fourth-largest issuer but also secured a bond buddy for the smart-beta driven issuer, according to Dan Draper, global head of ETFs at the firm.

In today’s environment, investors are itching to understand how fixed-income investing works with factors to be more precise with their bond bets, he said.

“That’s one of our big synergies with Guggenheim in bringing over their fixed income-focused BulletShares series,” Mr. Draper said. “We’re really accelerating our thinking process around fixed-income factors. That’s where a lot of our internal research and development work is focused right now.”

(More: Vanguard crushed active investing. Now it could save it)