I was recently speaking with an advisor who made some pointed observations about our ETF managed portfolios. He noted that several of our ETF holdings lack even a one-year track record and/or hold less than $100 million in assets under management.
He also voiced concerns about some ETFs not trading in sufficient size or volume, or even on a frequent basis. He more or less affirmed that, based on his own criteria for evaluating traditional mutual fund strategies, several of our ETFs would not even make it past his screens.
He couldn't understand how we can be comfortable holding such ETFs.
These are, of course, valid concerns, but they come from a traditional approach to evaluating active managers. Should an advisor use the same screening criteria to evaluate ETFs, particularly strategic-beta ETFs? Should advisors dismiss back-tested or simulated performance in lieu of a live track record?
Factor Investing: Replicating Smart Investor Behavior at a Fraction of the Cost
An investment approach based on strategic betas ultimately seeks to replicate smart investor behavior at a fraction of the cost (of active management). In the spirit of Fama/French, much of what an active manager delivers can be systematically replicated using factor portfolios mimicking active managers' styles and decision rules. However, many such strategies would get automatically screened out using traditional fund evaluation criteria.
Instead, investors should focus on four main criteria for evaluating strategic beta ETFs:
- ETF sponsor reputational strength and commitment to supporting the ETF
Strategic Beta ETFs - Small But Growing and Many of Which Wouldn't Meet a Traditional Screen
According to Morningstar Office, there are ~400 U.S- Listed Equity-Oriented Strategic Beta ETFs designated as "Return Oriented" or factor-based portfolios with $398 billion in AUM (as of 5/31/2016). Of these, 308 (or 77%) have a one-year track record, 227 (or 57%) have a three-year track record and 184 (or 46%) have a five-year track record (Exhibit 1).
Exhibit 1 - Many Strategic Beta ETFs Don't Possess a Long Track Record
In addition, 209 (or 51%) have $100 million or fewer in assets under management and 133 (or 33%) have $25 million or less. In fact, despite the growth in AUM, the top 20 ETFs (by AUM) comprise nearly 2/3 of AUM within this category suggesting that there is an opportunity for the strategic beta space to broaden out as more ETF strategies gain traction (Exhibit 2).
Exhibit 2 - Strategic Beta ETFs Dominated by the Top 20 (By AUM)
So advisors using traditional evaluation screens would most likely gravitate to the larger, more established ETF strategies. This would serve as the 'safer' approach but would leave them unexposed to much of the product innovation happening within strategic beta.
A Hypothetical Case Study - A Faux S&P 500 ETF
Consider this extreme, exaggerated hypothetical example to illustrate why a traditional screening criterion applied to mutual funds should not apply to ETFs:
Imagine, if you will, the 3D Faux S&P 500 ETF: This hypothetical ETF will be designed to capture the wisdom of the crowds based on the intuitive rationale that the collective wisdom is superior to any one individual opinion.
Basket securities will be weighted based on equity market capitalization, reflecting the accumulated value creation assigned by the market. It will focus on the largest 500 stocks by market capitalization and will be reconstituted twice a year.
This will be an index-tracking, passive ETF. For basket construction, we will use a stratified sampling approach that will not fully replicate the tracking index, but will minimize tracking risk by targeting index characteristics and risk exposures.
We will seed it with $10 million from a liquidity provider to get the fund launched, and the fees will be competitive to other similar strategies.
Finally, we have reasonable assurance that the 30+ liquidity providers will maintain active markets for Faux S&P and will compete on the bid/offer spread and will be incentivized to ensure the ETF price does not deviate too far from the net asset value.
How Traditional Screens Look At This
Using traditional fund evaluation criteria, clearly this fund would fail on two fronts:
- There is no track record, even though we could produce backtested results showing historical performance of this strategy incorporating reasonable trading costs.
Now, because of the near-universal awareness of the S&P 500 Index among professional investors, one would not be as concerned about the integrity of these backtest results because of the familiarity and comfort with a market-cap-weighted approach to investing. The key is that investors are reasonably confident in the underlying rule(s) that determines basket construction.
- There is insufficient AUM and liquidity for a sizable investment.
However, with ETFs, what is more relevant is the underlying liquidity of the basket holdings rather than the ETF itself. Using the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) as a proxy for Faux S&P, the implied liquidity suggests that $7.18 billion can be traded daily based on the creation unit (typically 50,000 shares).
Even though Faux S&P has low AUM, an investor could create or redeem in amounts that are multiples above the AUM of Faux S&P without having much market impact.
Ultimately, the appeal of this ETF will come down to: 1) attractiveness of underlying strategy; and 2) cost.
Because Faux S&P uses a mechanically driven, rules-based approach to basket construction, a lengthy track record is not necessarily needed to evaluate the merits of this strategy, unlike a traditional active strategy subject to human decision-making.
What Matters More With ETFs?
Now obviously, strategic- or factor-based ETFs are more complex than a simple market-cap-weighted approach. But the extreme example of Faux S&P does not present too much of a departure in considering why one should evaluate strategic-beta ETFs differently from traditional active strategies.
What to consider?
First: Design, Or What Exposure The ETF Seeks To Provide
Taking low volatility as an example, these are some aspects one should consider in assessing the underlying design:
1. Defining Low Volatility
- Statistical measures
- Fundamental measures (e.g., factors with low-volatility characteristics)
2. Basket Construction
- Purely score-based (no optimization or constraints)
- Guardrails on exposures (sectors, regions)
- Optimize toward a goal (low absolute risk)
- Bells and whistles (quality and yield overlay)
The two major low-volatility ETFs, the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) and the iShares Edge MSCI Min Vol USA ETF (BATS:USMV), are designed to achieve different results even if they both track the low-volatility style of investing. SPLV consists of a basket of low-volatility stocks, while USMV consists of a low-volatility basket.
SPLV consists of a volatility (inversely) weighted basket of stocks within the S&P 500 that have the lowest volatility. There are no constraints, such as sector.
USMV, on the other hand, is an optimized basket of U.S. stocks designed to achieve low volatility. The securities themselves may not possess the lowest volatilities, but their higher volatilities are offset by their lower correlations. It also has sector limitations.
Nothing New About Low-Vol Factors
The point is that these two low-vol funds are designed very differently. But most investors may have felt confident in these strategies without a track record because the low-volatility anomaly has been well-documented.
That may not be case for more complex ETFs, such as those designed to be dynamic (e.g., rules that can shift the underlying exposure through time), or those with bells and whistles (e.g., quality and yield overlays).
Even if backtests could be generated to produce reasonably reliable results, there is always the off chance of data mining or seeking the solution that looks best at a certain point of time. They require a deeper level of sophistication.
Second Consideration: Implementation
The Faux S&P uses a stratified sampling approach as opposed to full index replication. Not every company in the tracking index will be held in the ETF, nor will the weights fully map to those of the index.
However, good ETF managers can deliver the desired exposures of the tracking index while minimizing costs, as well as engaging in tax loss harvesting. Ultimately, the investor needs to be comfortable that the rules driving ETF basket construction can reasonably replicate the tracking index.
This may be more of an issue with less liquid markets such as high-yield fixed income and emerging markets, but the tracking differences tend to be reasonably small relative to the trading costs of full replication.
Third Consideration: Cost
Since strategic betas tend to be mechanically designed with little human intervention, the costs should be lower than traditional active management. Most strategic-beta ETFs tend to be priced within striking distance of pure market-cap-weighted ETFs, and that gap is narrowing, particularly in the U.S.
Fourth Consideration: ETF Sponsor Reputation
This is important, particularly in strategic beta, where it is harder to gain traction than more traditional ETFs. Whether the intellectual property resides with the ETF sponsor or index provider makes little difference; investors ultimately want to be assured that the ETF sponsor remains committed to the space rather than just reacting to recent market trends.
Final Consideration: Know What You're Buying
When investors allocate funds to an active manager, they are somewhat confident they know what is being delivered: superior security selection or tactical positioning. A long, solid track record and sufficient AUM make sense for evaluating active managers, since they represent two key proofs of concept for assessing the viability of active strategies.
These considerations are not as relevant to evaluating strategic beta ETFs, which are driven by different proofs of concepts such as design, implementation, cost and sponsorship. ETF investors must ultimately feel comfortable with the exposure they are allocating to.
At the time of this writing, 3D Asset Management held SPLV and USMV. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of June 23, 2016, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm's Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing email@example.com or visiting 3D's website at www.3dadvisor.com.
Disclosure: I am/we are long USMV, SPLV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.