Interview with the Global Head of ETFs Ken O’Keeffe of FTSE Russell

ETFdb: Please tell us about yourself and FTSE Russell.

Ken O’Keefe (K.O.): Last year, the London Stock Exchange Group combined FTSE and Russell into one company, and prior to that I was with Russell Indexes. In terms of FTSE and Russell coming together, it’s really a fantastic combination of two businesses. When you think of Russell you think of U.S. equity, and you think of the U.S. market. When you think of FTSE, you think of international equity and FTSE 100. And so the two brands are complementary. 2015 was the year of bringing the two companies together, and now that’s essentially complete. What we’re able to offer to clients are two very respected brands. There’s no index provider that has our strong global offerings: U.S. domestic, U.K. domestic, and international.

We’re now truly a global index player. We have many clients that are either global themselves or aspire to be global. Therefore, the fact that we can support them not only in the U.S., but also in Canada, in Europe, and in Asia Pacific is very important to them. That support is not just business and ETP people like myself; it’s also our research client service and data teams, and so on. Combined, the two companies have about $10 trillion in assets that are benchmarked to our indexes, which creates a ready audience for almost any new index that we bring out.

ETFdb: Given the information that we just talked about, what would you say is FTSE Russell’s overall strategy in terms of ETFs?

K.O.: Our ETF strategy is to continue to work with the clients and partners that we already have to help them drive awareness and education around the indexes that form the basis of their ETFs.

We recently completed a survey among retail financial advisers in the U.S. When you look at investing in ETFs, the number one reason why financial advisers don’t invest in an ETF is education. Some advisers lack the understanding of what exactly this product is. And it’s not the ETF they don’t understand; they understand its structure, how it is priced and where to buy it, but they don’t understand the inner workings of the ETF, and may not understand the index. So that’s the reason why we are at conferences like this; education is so important. Our main strategy in working with clients is supporting them and helping them drive education, awareness of the indexes, and then, of course, they’re trying to drive assets into it.

And in terms of new products, our strategy is to continue to drive awareness of FTSE and Russell brands to financial advisers and end users, then also develop new and innovative products that help them meet the needs of today’s market environments. We’ve launched several products with various ETF providers in the U.S. this past year that really address what’s happening now in the market such as the recent downturn and higher volatility. One ETF provider we worked with recently to create low volatility products in December was SSGA, when we launched the Russell 1000 Focus Factor Low Volatility Index, and they launched it as an ETF.

ETFdb: Could you tell us a little bit more about that specific product?

K.O.: Sure, we start off with the universe of the Russell 1000. We apply three factors to gain factor exposure and factor diversification. The three factors are quality, value, and size. And the focus factor is low volatility. There are two other sister products, one is focused on momentum and the other is focused on yield, but they all start with the Russell 1000; and then those three factors of quality, value, and size. The reason why that’s attractive to investors is that there is a lot of academic research on how factor-based investing provides superior returns in comparison to the market. However, single factors can often go through long periods of underperformance, even though over very long periods of time they typically outperform.

But when you combine factors like quality, value, and size, you’re able to smooth out some of those longer-term underperformance periods. These three factors in particular work really well together. When you think of value, you’re basically trying to tap companies that are underpriced. Well, sometimes companies are underpriced because they should be underpriced. If you provide a quality screen first, then you avoid what we refer to as a “value trap.” The same idea goes with size. There is a premium seen on size, but sometimes smaller companies aren’t necessarily higher quality. When you add the quality factor to the size factor it helps to identify higher-quality small companies. So now you have this enhanced index and you add the low-volatility factor to it, and it gives you that low-volatility focus. So we have a momentum focus, and then we have a yield focus. But a low-volatility product has to perform exactly as described. By way of example, the SPDR Russell 1000 Focus Factor Low Volatility ETF (ONEV B+) has outperformed the standard Russell 1000 Index by two or three percentage points during the most recent downturn. That was developed with SSGA.

Another product we developed with PowerShares last November was low-beta equal weight. It takes the Russell 1000 and looks for all the securities that have a beta lower than 1. It also provides a profitability screen to make sure you’re getting higher-quality names, and then we equal weight the resulting basket of securities.

ETFdb: When you have a beta that’s lower than 1 you’re trying to stay away from following the market, essentially. Why is that the focus?

K.O.: This particular investor or client was looking for systematic lower volatility. So if you want just low volatility that’s usually on a single stock. Low beta, as you pointed out, is relative to the market. So you want this portfolio to always have a beta that’s lower than the market itself. Therefore, when the market falls, like it just has for the first three weeks of the year, this particular index was outperforming the market. PowerShares has launched two ETFs on this index methodology. One based on the Russell 1000 and the other on FTSE Developed ex-U.S.

The last one that I think is very interesting is a much smaller ETF provider, O’Shares. Kevin O’Leary came to us with a problem. His challenge was that he wanted to develop a long-term portfolio that he can use to not only create ETFs, but put his own family’s trust money into. He’s trying to solve a problem of really long-term investing that goes beyond his lifespan. And when looking at all of the ETFs in the market, he didn’t find any that met his criteria. So he was looking for something that paid a dividend; that was really important to him. And there’s a lot to be said for that. Look at the performance of the Russell 1000 over the past thirty-odd years, somewhere around 60-70% of the performance comes from yield. So Kevin wanted yield-paying stocks, higher-quality names, and low volatility. Basically, he wanted this very boring index. But it’s an index that through tough markets, as well as through good markets, does quite well when you look at the historical performance of the index. So it actually took us awhile, and it’s one of the interesting things about working with ETF providers. You have to really understand what they are trying to solve. He liked the quality yield initially, but he also wanted to reduce the volatility.

I was just meeting with O’Shares about how their ETFs performed relative to relevant benchmark indexes. They pointed out the outperformance of three and four percentage points since launch, and how they are reducing volatility in a market that now has got a lot of volatility.

ETFdb: What is your perspective in terms of ETFs going forward?

K.O.: There is clearly a movement from active mutual funds to passive ETFs. And some of those ETFs are truly passive in terms of being market-cap weighted, based on the Russell 1000 and 2000 Indexes, and in other cases it’s on rules-based smart-beta products like the ones we were just discussing. I think a lot of what’s driving that is the advantages of ETFs; they are more tax efficient than mutual funds and are tradeable at any time during the day.

Furthermore, relative to an active mutual fund, there’s transparency. The market knows exactly what’s in the ETF. And Kevin O’Leary has a lot of interesting ways of talking about this. Because he doesn’t refer to it as smart beta; he refers to it as a rules-based methodology. There are rules that are applied here, and the rules ensure that there isn’t any behavioral economics getting involved. For example, the rules always say that, if this particular security becomes highly volatile next rebalancing period, it’s out of the index. Another rule: if this security isn’t a high-paying yield security during the rebalancing period, it’s also out. For some reason, this company is no longer a high-quality company, because they have balance sheet issues or other reasons, it’s out of the index at the next index rebalance. Whereas, an active portfolio manager might say, “No, I’m going to wait a little while longer before I remove this stock from the portfolio.” Rules-based methodology gets rid of that kind of behavioral bias. Therefore, you don’t get style drift; you get exactly what you’re expecting to get.

ETFdb: What were some of the insights from this conference?

K.O.: One of them is that there’s going to be continuing interest in smart beta because it is such a complementary product to active mutual funds, and traditional passive ETFs or passive mutual funds based on market cap-weighted indexes. One of the interesting findings coming out of our own retail survey is: don’t call it smart beta. If you ask a financial adviser, “Do you use smart beta?” Only 35% raise their hand. If you ask financial advisers, “Do you use equal weight portfolios?” “Do you use fundamental portfolios?” or “Do you use factor portfolios?” 68% raise their hand. So smart beta is kind of an insider industry term. It makes much more sense to talk about individual strategies as opposed to smart beta broadly. But financial advisers see smart beta as being complementary to active strategies, and a lot of times per our survey they look at smart beta similarly to the way they look at active strategies.

When you look at one of the main reasons financial advisers, according to our survey, use a smart-beta ETF, it’s because they are looking for downside protection, lower volatility, increased alpha, diversification, and yield. Those are all things that you don’t get from a typical market cap-weighted product. When you think of the Russell 1000, it doesn’t necessarily give you downside protection or lower volatility, it gives you the performance of the U.S. market. Whereas, for example, the Russell 1000 low-beta, equal-weighted index gives you downside protection and low volatility.