Charles Schwab’s Experts Share Their Insights on Smart Beta and Smart Beta Trends

ETFdb.com (ETFdb): Please introduce yourself.

Anthony Davidow (A.D.): My name is Anthony Davidow and I am Vice President, Alternative Beta and Asset Allocation Strategist for the Schwab Center for Financial Research. The Center is an independent think tank within Schwab, so I have no product affiliation at all. Our goal is to help our clients make better informed decisions.

Mike Savage (M.S.): My name is Mike Savage and I am a Managing Director & Portfolio Strategist representing Charles Schwab’s fundamental index suite of mutual funds and exchange-traded funds. We have six mutual funds and six exchange-traded funds. Our Schwab fundamental index products are our entry into the smart beta world. We have almost nine years of data on the fundamental index to follow, as the mutual funds were launched in 2007 and 2008. The ETFs, on the other hand, are less than three years old.

ETFdb: Every investor has a different definition of smart beta. Some call it strategic beta, others call it additional beta. In your opinion, what is smart beta? What would you suggest to investors and advisors when evaluating and choosing a smart beta ETF?

A.D.: We like Morningstar, who have created a taxonomy that describes strategic beta strategies. They have three broad descriptors that they start with: Risk-Oriented strategies, Return-Oriented strategies and Other strategies (which are strategies that are not risk or return oriented). I think it’s a good starting point, but we need to spend more time helping individuals understand the subtle differences among the various investment styles and rebalancing strategies.

In our paper, Strategic Beta Strategies: An Evaluation of Different Approaches, we take investors through several popular strategies via a step-by-step process and help evaluate these individual strategies. Firstly, investors should understand what the ETF is trying to accomplish from a goal standpoint. Fundamental strategies may weight securities on factors such as sales, cash flow, dividends and buybacks. Secondly, investors must evaluate the potential concentration risks within the ETF – both from a sector and a geographic standpoint. Finally, investors must evaluate the security weighting strategy – whether it is equal weighted, market weighted or fundamentally weighted, and the frequency with which the ETF securities turnover. How these affect the expense ratio and ETF performance are paramount for investors.

M.S.: These are all interchangeable terms that broadly define a segment of broad market investments that select and weight securities in some manner other than traditional market-cap weighting.

Given the ETF proliferation, it is important to differentiate among the various offerings. In our view, a successful smart beta strategy accomplishes three things. First, it maintains the benefits of traditional indexing such as low cost, low turnover, high transparency and tax advantages. Second, it breaks the link with price. In this market environment, there is a lot of cash chasing relatively few assets, which means that traditional index products are often going in the same direction in terms of weighting and emphasizing certain names/sectors. Breaking this link is important for a smart beta product to be effective. Finally, the strategy must be understandable and explainable to a wide range of people.

ETFdb: Do you think every investor should have some exposure to smart beta in their portfolio? What are the advantages of investing in these types of active beta ETFs, as opposed to investing in passive ETFs?

A.D.: Yes, we do believe that every investor should have smart beta exposure. We have a bias for fundamental indexing, because of the richness and robustness of the data. The underlying methodology is easily understood, and these strategies will be given an opportunity to be implemented over time.

We believe that fundamental and market cap-weighted strategies complement each other. Market cap-weighted strategies give you the consistency and expected outcome of a particular asset class at extremely low price points – considerably lower than strategic beta strategies. Fundamental strategies, based on our research, generate excess return over long intervals.
The combination of the two strategies, fundamental and market cap weighted, actually provide a better risk-return outcome – as well as a lower cost point – since the fees are blended.

M.S.: We think the fundamental index with broad market exposure serves a wide range of investors. In our managed solutions for retail investors, we generally combine traditional cap-weighted investments and fundamental index strategies on roughly an equal weighting basis. Not all smart beta strategies are created equal, so it is important for investors to understand the underlying strategies.

A fundamental index tends to improve your diversification and seeks to provide potential higher returns over longer time periods. I think it should be a core investor holding as part of a strategic allocation.

ETFdb: Charles Schwab has three U.S.-based fundamental index ETFs – (FNDB A-), (FNDX A) and (FNDA A). Schwab also has three international fundamental index ETFs – (FNDF B+), (FNDC A) and (FNDE A) . What are the fundamentals these ETFs focus on? Can you discuss the rationale behind that focus?

M.S.: The three metrics used in our fundamental index methodology are adjusted sales, retained operating cash flow and dividends plus buybacks. Developed in conjunction with our research partner Research Affiliates, these fundamentals provide an objective anchor to select and weight securities. It was important to select financial measures that are consistent in their reporting globally across borders.

We are trying to break the link with price on a systematic and periodic basis to generate excess return. We recognize that when we have multiple factors, some factors will perform better in a particular market environment than others. Other fundamental index strategies focus on value metrics such as price to earnings, price to book or price to sales. All of these, by definition, are related to price and don’t break the link to price. Even momentum is linked to price because it is a measurement of price activity over a specific time horizon. Breaking the link with price is a core component of our fundamental index strategies.

ETFdb: What are some smart beta trends you see evolving in the ETF space over the next few years?

A.D.: I think there are two major trends that will play themselves out in the near future. First, you will continue to see more multi-factor strategies coming to the marketplace. Second, you will start to see more smart beta fixed-income, commodity and/or broad alternative strategies in the ETF space. This is because most of the growth to date in the smart beta area has been in the equity space.

ETFdb: Do you think investors are moving towards all-ETF portfolios? Or do you think mutual funds and ETFs can complement each other in investor portfolios in the future?

M.S.: We think there is a place for both ETFs and mutual funds in investor portfolios. ETFs are gaining a fair amount of growth because they are the lower cost option. However, several investors and advisors are comfortable with mutual funds because they may have owned them for long time horizons, may not be focused on daily/active trading and perhaps prefer to buy a mutual fund at its stated NAV.

ETFdb: How do you see the ETF industry evolving over the next five years?

A.D.: The landscape has changed significantly over the past five years. We will continue to see an acceleration of that. There will likely be more blurring of the lines of active and passive. In fact, you may see a growth in active ETF strategies from several active managers; the ETF is merely the wrapper that delivers the end-solution. It would not surprise me if there is consolidation of these strategies. An argument can be made that there are too many products in the marketplace. I think it would be a healthy exercise. If the ETF lineups and strategies are not terrific, then you could see some of these strategies closing over time. You’ve already started to see that trend. Consolidation, broadly speaking, would be extremely healthy for the ETF industry.

M.S.: It is certainly an important issue, and one that we think about. We feel that there will be several ETFs that won’t survive longer. Examples would include ETFs that do not generate enough assets under management (AUM) or are extremely specialized/niche ETFs. Schwab is about offering investors core foundational products that they can hold over time in most market environments. The last thing we want to do at Schwab is to close or unwind an ETF. It is important for ETF issuers to be thoughtful about how they launch new ETFs.

In my opinion, the issue of scale is going to be the biggest factor that drives future ETF activity. Many ETFs will not survive. As the industry matures, the question will come down to survival and if the new ETFs can meet those minimum scale requirements/thresholds. You might see ETF firms experiencing slower growth and having to unwind some of their funds.

Smart beta products will continue to proliferate the ETF industry. Charles Schwab’s fundamental index ETFs break the link with price by focusing on fundamental factors such as sales, cash flow and dividends plus buybacks. A core fundamental index can provide diversification benefits, as well as potential higher returns over extended time horizons.