Fund managers warned on exotic ETFs

Smart beta, the increasingly popular index-investing strategy, is drawing fresh scrutiny from industry analysts and regulators who say new products need to be better tested before earning a place in investor portfolios.
The funds, which straddle the traditional division between “active” and “passive” investment management, have become a fashionable way for fund managers to meet the growing demand for exchange-traded funds without merely copying market-tracking funds that already exist.
“You certainly have to distinguish your indexes,” said Bill Donahue, a consultant to money managers at PricewaterhouseCoopers. “We’ve cautioned people to do more beta-testing on how these products might work in different economic environments, and to think through how the fund is going to be in terms of regulatory and tax issues.”
Proponents of smart beta generally hold the view that financial markets can be beat in predictable ways and that the factors generating long-run outperformance can be boiled down into a set of trading rules that money managers can implement at a fraction of the cost of active management.
Depending on the definition of smart beta, flows into products account for anywhere from one-tenth to half of the money flowing into ETFs, the most popular product in asset management.
Yet a number of advisers and analysts are not confident enough to invest in smart beta strategies given the lack of real-life performance data from fund managers and index providers.
“If anyone’s creating something new they can always create the rules to make it however they like,” said J.J. Feldman, investment manager for Miracle Mile Advisors Inc., a registered investment adviser. “You have to take it with a grain of salt.”
At issue are the sometimes intricate set of rules encoded in benchmarks that try to improve upon the returns — or diminish the risks — of traditional indexes. Index companies say they are careful to construct benchmarks that are investible and perform as advertised.
But the Financial Industry Regulatory Authority Inc. said last month in a letter outlining its regulatory priorities that it plans to focus on the funds. The regulator said it was an “open question” how the funds would perform in “different market environments going forward.”
ETFs attempting to track those “smart” rules can be less liquid or require managers to trade securities more often than traditional index funds, a phenomenon known as turnover that can contribute to higher tax liabilities and transaction costs for investors, according to the industry-funded regulator.
Some recent studies have found that a number of strategies labeled smart beta fail to deliver on providing superior risk-adjusted returns to plain indexes.
“By making smart beta out to be the new El Dorado as a cheaper form of alpha, smart beta providers are not serving either investors or themselves well, because they can create disappointment,” said Noël Amenc, a professor of finance at EDHEC Business School and director of an indexing business affiliated with the French university.
While not all smart beta funds trade easily and cheaply, many of the largest funds associated with the term do.
The iShares MSCI USA Minimum Volatility ETF (USMV) and the FlexShares Morningstar U.S. Market Factor Tilt ETF (TILT), for instance, typically trade with limited transaction costs and at minimal variation in performance from their underlying indexes, measured by their bid-ask spreads and tracking difference, according to an analysis conducted for InvestmentNews by ETF.com. Both of those factors contribute to the cost and performance of an ETF.
Fund managers from Goldman Sachs to J.P. Morgan have been adding or proposing to add to the smart beta trend.
Many of those managers missed the fast growth of the $2 trillion U.S. market for ETFs during its infancy and don’t want to be left out of the industry’s widely predicted next wave of growth, which is expected to come at the expense of mutual funds, stocks, bonds and other investment products.
Yet not all of the push for exotic indexes is coming from the top-down.
After Research Affiliates promoted a 2013 paper in the Journal of Portfolio Management suggesting a dart-throwing monkey would outperform traditional indexes, financial advisers asked if the firm could turn simian stock selection into a rules-based index. In such a situation, the index would use a random-number generator instead of a company’s market value to decide how to allocate funds among the companies in an index.
Research Affiliates — a chief promoter of smart beta and an index-provider for Pimco and Schwab funds — demurred, according to Brent Leadbetter, a product specialist at the company.
Mr. Leadbetter said funds following the monkey benchmark would likely have high turnover and tracking difference.