The ETF Database team had a chance to meet with Steve Deroian, who is the Head of ETF Strategy at John Hancock, at the Inside ETFs Conference in Florida in January 2017. The Director of ETF Capital Markets, Will Creedon, also sat in on the meeting to discuss investor due diligence. In this Q&A session, Mr. Deroian explained the reasons why John Hancock chooses to launch Smart Beta ETFs only. He then explains the Dimensional approach and its diversification benefits. We also talk about the overall market trends and the ETF industry as a whole.
ETFdb.com: Please tell us about yourself, and your role at John Hancock.
Steve Deroian (S.D.): I am the Head of ETF Strategy at John Hancock. I joined about six months ago. It has been a fantastic six months. It is great to work at a firm that has such a large footprint in the industry, but also is into heritage, family values and other employee-focused benefits that make it a great place to go every single day.
What has been nice about the entrance we’ve had into the ETF space has been that it has really followed along with what we’ve been doing on the mutual fund side for quite a long time. So it is really playing nicely into what our strengths are, which is our manager-of-manager model. We focus in on finding the best of the best in a particular asset class, or a particular subject field. We do a tremendous amount of due diligence across the platform. ETFs are just an extension of what we do on a daily basis.
Smart Beta ETFs
ETFdb.com: All of John Hancock’s ETFs are Smart Beta. Everyone has a different definition of what Smart Beta is; they call it strategic Beta or additional Beta. In your opinion, what is Smart Beta?
S.D.: When I think of strategic Beta, I think the simplest answer is if it’s not market cap weighted, it’s strategic Beta. I think that’s the answer that everybody wants to hear. But I think the reality is strategic Beta is an evolution of active management. It’s just a slightly more efficient way to deliver the things that everybody has been asking and looking for for years, which is a means to hopefully beat the market on a somewhat consistent basis.
I think for us, and one of the reasons why we partnered with Dimensional Funds, is that what we do know is it is difficult to beat the market. So to partner with a firm that has a heritage of doing so, like Dimensional Funds, is what really excited me about the job and the opportunity. What separates us from other players in the space right now is that they don’t have the breadth of experience that our sub-advisor does.
ETFdb.com: What are some of the benefits or risks of Smart Beta investing?
S.D.: I think the biggest risk with Smart Beta investing is not knowing what you’re investing in. There is a place for single factor Smart Beta investing, as some might refer to it, but I think it probably lives in the same place that any other difficult to expose factor would. So single factor is great when you feel like you have an opinion that you want to time, but I think it’s really hard to do. So what I love about the multi factor space is that if done correctly, it gives you a more core portfolio option. I think the satellite-type options are more of your single factor opportunities.
Read Smart Beta ETFs Can Help You Navigate the Market Cycle to find out about the individual factors within Smart Beta ETFs.
ETFdb.com: What do you think is the future of Smart Beta?
S.D.: I think it will grow, I don’t think there’s any question about that. Again, I think, as I said at the beginning, it’s really that evolution of active, that when you think about the value that an active manager is adding, a lot of that can be tied back to the factors. So if you can deliver a lot of the value of what an active manager is doing, and you can lower the cost, maybe that’s enough. Maybe it’s not enough, but at least it’s that third choice that I think is really important.
ETFdb.com: What role should diversification and international exposure play within the portfolio? Because I know you have the John Hancock Developed International ETF (JHMD ).
S.D.: It just recently launched actually, which is great. We are taking a thoughtful approach to how we’re building our lineup. The next evolution for us was further diversification. We had pretty good coverage in the U.S. with our large and midcap products, and then of course our sector products. We launched the Developed International, which is really an ex-North America index, if you will.
What’s unique about the Dimensional approach, which we’ve incorporated into our ETFs, is diversification. You see it in the construction of our Dimensional indexes and how it translates to our ETFs. For instance, our large cap ETF is 750 to 800 stocks; it’s a large ETF. You see the same thing on our developed side, and our midcap side. Those are over 650 and almost 700 stocks on the developed side. So not only do we believe in building client portfolios through diversification, but within the individual segments of that portfolio we believe in diversification.
Seeing a Dimensional product that has 600 stocks in it on a developed international side gives the product itself a level of diversification that is unique when you talk about multi factors. A lot of the multi factors, not all, but some really pare down the universe. Certainly some of the single factors are doing the same thing. Part of our differentiation in the Smart Beta space is diversification within the product itself.
ETFdb.com: In your opinion, what’s the rationale behind combining multi factors? Ultimately speaking as an investor and as an advisor, what would be some best practices when it comes to evaluating the merits of these underlying methodologies? What combination of factors are important?
S.D.: I think there are some tried and true factors. Some people quote 100 and something, some people quote 40 something. It’s probably six or seven that are real that investors have shown interest in, and that the academic research actually proves out. So obviously the market itself, size, value, profitability, low volatility, quality which is under profitability and momentum. Those are the tried and trues.
It’s difficult to combine them. That’s why what we decided to build and partner with Dimensional was more of a multi factor. We wanted to let their 30 plus years of experience speak for itself. There are rocket scientists in that building that are putting together the models for us.
It’s difficult for advisors to pick and choose when is the right time to get in, when is the right time to get out of these factors, which factors to be in and which factors to be out of.
We partnered with a firm that shows the academic rigor that Dimensional has. So the factors that they and we include in our ETFs are size, relative price, (value) and then of course profitability, or quality, depending on what your point of view is. We also have a little bit of a momentum element in there during our rebalancing times. We acknowledge that momentum has a place in the discussion, but not at the same level as what I might call the big three coming from Boston. But that’s a tough question. It’s one that I don’t think advisors are asking themselves enough when choosing a single factor product.
John Hancock ETFs
ETFdb.com: Let’s talk about the family of John Hancock multi factor ETFs. In particular, the combination of factors that you guys use. Can you discuss why you decided to focus on these four factors in particular?
S.D.: Dimensional model is based on 57 years of academic research and 30 years of implementation. So why Dimensional has selected those is because they’re robust. They are persistent, and they truly are seen throughout history. They are seen throughout time, and they are seen across multiple venues. These are not factors that just simply show up in the U.S. at certain times, or in the international markets during certain situations. From 1927 to now when you look at the data, and the data is available on Ken French’s website for free, the data proves out that these factors that are used are persistent. They have been shown to create a premium that you want to capture. The difficulty is, when do you own it, how do you own it? I don’t know when they’re going to show up.
Dimensional approaches these premiums expecting them to be positive every day. They recognize that a positive premium will not be realized on all days, but they’ve also found no reliable evidence to say you can predict which days the premiums will or won’t show up. So when you put it into that context, how do you use them? Well you’ve got to be engaged in the factor persistently. That’s the reason why those are the factors they selected. Three months from now, three years from now, 30 years from now, we may add another factor into the model, but it will be done because there has been academic research that has shown that it’s the right thing to do for the client portfolio, not because it’s the hot dot, or someone came up with a really neat idea. It’s going to have a whole slew of data behind that addition.
Investor Due Diligence
ETFdb.com: Before I move into some of the current market events that are happening, a question for both of you. What would you say are three best practices for investors when it comes to doing ETF due diligence, as well as ETF trading due diligence?
Will Creedon (W.C.): I think when it comes to ETF due diligence, and ETF product selection, the three pillars I would say are most important to potential investors are, to one of Steve’s earlier points, very similar to that of traditional manager selection. So I would say at the outset you define is this a short-term or a long-term idea that I want to implement. Secondly, you do traditional due diligence on people, process and performance, similar to that of an active manager. Then on the trading side I would say that understanding the dynamics of the liquidity of an ETF, and not just the trading volume, is one of the most important things you can do. Because I think one of the most important things that the investor should know, and even more so outside the equity space, is will liquidity or volatility characteristics change on the way into this ETF, versus the way out of this ETF.
Then finally I would say in the trading sense, try to understand the concept, when you’re doing due diligence, of the overall total cost. How much is the expense ratio, how much am I going to pay in bid ask spread every time I get into, or out of, the ETF. Then lastly, think about costs that may not be as transparent as an expense ratio. Think about things like turnover at the portfolio level, tax efficiency at the portfolio level, and ultimately other hidden risks and costs that might not necessarily be on the fact sheet.
S.D.: Just to expand on the people process and the performance elements, I think that occasionally, because of the heritage of ETFs, and their background as more of a Beta product, that element has been overlooked. As you think about strategic Beta products, as you think about active ETFs, I think people are going to have to bring that back into the conversation, and really do some digging. Because there are six, seven, eight of us providers out there, that you can choose now a multi factor product from. What is the background, who are the people that created the index, what is their background? Who are the people that are managing the process, what is their background? What has the performance been of the index? What should you expect?
To me the biggest risk, whether you’re an advisor, whether you’re talking to your kids or your spouse, is expectations. If you are promising something you don’t think can be delivered, that’s not going to go well for you. So I believe that it’s difficult in the strategic Beta ETF space right now, because the ETFs are all pretty young. There’s not a lot of tenure for the products, but for us, we have Dimensional on our side.
ETFdb.com: I just want to talk about the current financial market environment. Geopolitical risk is everywhere right now. You’ve got Trump, you’ve got Brexit, you’ve got Italy. There are a lot of trade wars, currency wars, you name it. So having said that, how do you recommend to your clients in terms of how they should be navigating this geopolitical risk over say the next eight to 12 months?
S.D.: Over the course of time what we’ve learned is that it is extremely difficult to say. If you said to me on November 7 or 8 that the market was going to do what it did after Trump won, I would be shocked. I didn’t hear one individual say, not one, that a Trump win would result in what we now are affectionately calling the Trump bump. So I think you do the best you can do, which is talk to your customers and your clients, and do consistent asset allocation that matches what their risk profiles are.
You have to know your client, if you don’t, that’s where the risk is. If your client truly can’t accept 60 percent exposure to equities, then you need to understand that, you need to know that and you need to own that relationship. So to me you can’t just look at the math, you can’t just say, you’re in your 40s, you should have X amount of exposure to equities. I think that’s the mistake that we get caught in. I think that the reality is when clients fill out the questionnaires about what’s your risk tolerance, no one tells the truth. They don’t mean to lie, but they do because they think they’re more willing to be riskier than they are.
So I think it’s incumbent upon advisors to be honest, and to be forthcoming, and to really be willing to scare their clients a little bit with the truth. The truth is I don’t know what tomorrow is going to bring. I think that over the long haul, if you are in your 40s you’ve got 20 years to work. If you are truly risk averse, I’m going to treat you more like a 60 year old than a 40 year old, so I’m going to tilt that model that way. You think you’re going to live to 100, and you’re 45, I’m going to treat you more like a 20 year old.
The bottom line is that it is one of the most difficult jobs in the world, being an advisor, because you really have to draw the truth out of your client, and that is really difficult. To me it’s not an easy thing to navigate, but I think it’s a fool’s errand to think that you can’t or shouldn’t try.
ETFdb.com: What are three future trends you have to expect over the next few years in the ETF industry?
S.D.: Active and strategic Beta both will grow. Fixed income will grow. Expense ratios will continue to go down.
ETFdb.com: You mentioned ETF fees. Many issuers are cutting fees, including Vanguard and Blackrock. One of the things I noticed is the pressure on fees is more on broad market exposure ETFs, as opposed to niche Smart Beta ETFs. Do you see this trend continuing and fees going down to zero?
S.D.: I will say if it goes to zero it will be because someone is getting paid in a different way. There are spots out there in the market where people think something is zero. Well it’s not. There is nobody doing anything for free. So do your diligence, figure out why something is zero, because there is probably some other way in which the firm is making money that isn’t as obvious. Those of us who are in the asset management business need human beings and technology to deliver those solutions. We can’t do it for free. At a certain scale the dollars change. So the folks that are lowering prices have a tremendous amount of scale in those particular products. Or they may have another mechanism to get compensated. That’s where I think people need to just continue to be smart about what they think is free.
W.C.: The only comment I’d make there is if you’re thinking about or looking at the fee compression the entire industry is under, I’d put it under two buckets. One is how low can Beta go. I think there is this true sense of this race to zero where people might be getting compensated in other ways, but there’s this race to zero. I’d also put in another bucket, the fee pressure that truly value-added strategies are under. To Steve’s earlier comment, it’s really a redefining of what active management is, and now we’re talking about a redefinition of what active management costs. I would argue there is a process driving to zero in simple market exposure Beta, but there’s also fee compression, not as stark, but certain fee compression in what is truly value added, or alpha generating managing styles.
Find out the top 100 Lowest Expense Ratio ETFs here.
The Bottom Line
Smart Beta ETFs are likely to continue to gain popularity among investors as the education level on the subject becomes more widespread. Furthermore, as the ETF industry expands further fees are likely to continue to decline. However, there is no free lunch when it comes to the asset management business, so investors need to be aware of other compensation mechanisms in the industry, as Mr. Deroian mentioned. As for selecting the right ETF, investors and advisors should do their due diligence and choose holdings in their portfolio based on their unique requirements and constraints, regardless of what’s happening in the market.
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