The evolving ETF industry continues to spawn innovative products that are democratizing the investment landscape in more ways than one. Most recently, the wave of “Smart Beta” products has brought forth strategies that were not too long ago simply out-of-reach for the average investor.
We recently had the opportunity to talk with Mike McGlone, the Director of Research at ETF Securities in the U.S., about his firm’s expansion into the smart beta arena and the recently launched Diversified-Factor U.S. Large Cap Index Fund (SBUS) and its Developed Europe (SBEU) counterpart.
ETF Database: What motivated ETF Securities to broaden your product range from commodity-themed products and into equity-focused ones?
Mike McGlone (MM): Today we offer our European customers one of the most comprehensive ranges of specialist exchange traded products (ETPs) covering commodities, FX and thematic equities. In parallel, ETF Securities is actively looking to expand the range of products we offer to our customers in the US.
By working with best-in-class third parties, we continue to seek out the most relevant opportunities and make them accessible to investors as intelligent alternatives. Investor feedback told us they trust us to provide them with new solutions beyond our traditionally commodity-focused products. In response, we have worked closely with the EDHEC Risk Institute/Scientific Beta to develop genuinely new products which enable investors to further diversify their portfolios combined with greater potential for out-performance.
By working with ED-HEC, we are able to offer a strategy, focused on ‘Smart Beta’, specifically what they call Smart Beta 2.0. We recognize a ‘one size fits all’ approach does not best serve the needs of investors. So we have built a range of products to better fit with the particular needs of all the investors being targeted, namely institutional as well as retail/mass affluent.
ETF Database: What is the methodology behind the Diversified-Factor indexes that power the recently launched SBUS and SBEU? How does it actually work? How does it rebalance?
MM: The ETFS Diversified-Factor U.S. Large Cap Index Fund (SBUS) and ETFS Diversified-Factor Europe Developed Index Fund (SBEU) track indices designed by Scientific Beta, an index provider specializing in smart beta solutions. Scientific Beta is part of the EDHEC Research Institute, an entity that seeks to help institutions implement academic research and improve their investment and risk management process.
Scientific Beta has developed smart beta solutions to address simultaneously the two potential issues of market cap weighted indices, i.e. lack of diversification and exposure to non-performing market factors. This comprehensive approach differs from most of the other smart beta indices which generally focus on either one of the issues, often resulting in sub-optimal risk/return performance.
Scientific Beta follows a well-defined 2 step-approach:
- Select stocks based on factors that have been well documented by academic research (low volatility, valuation, momentum and size)
- Use a proprietary weighting strategy focused on enhancing diversification
The indices are rebalanced quarterly. Replication costs and potential capital gains taxation are intended to be minimized by seeking to limit annual turnover to 35%.
ETF Database: How are these two ETFs similar to existing “Smart Beta” offerings that target domestic and foreign stocks respectively? How do they differentiate themselves?
MM: In the US, most of the smart beta offerings can be considered Smart Beta 1.0 as they generally address only one of the key issues with traditional market-cap benchmark type indices: factor tilt and concentration. Market-cap indices naturally tilt exposure towards (i) growth stocks and (ii) the largest market-cap stocks. Concentration: It is generally expected that most indices seek to provide well diversified exposure. Interestingly though, market-cap weighted indices can be considered as not properly designed to do so.
A potential solution – Smart Beta 2.0.
The EDHEC Risk Institute (ERI) is an academic institution focusing on applied research for the investment industry and is widely followed among large institutions, in particular pension funds and endowments. In 2012, ERI Scientific Beta was created with the objective of bringing scientific rigor to smart beta indices. Their solutions aim at addressing the potential issues of market-cap weighted indices by distinguishing factor exposures and weighting strategies.
ETF Securities is the first provider in the US market to offer products tracking indices from ERI Scientific Beta. These ETFs seek to provide broad market exposure by combining the four current well established factors, while the weighting strategies aim to maximize the exposure with a goal of improving overall risk adjusted performance.
ETF Database: Would you consider SBUS and SBEU as core, or more tactical, holdings? What else might investors find appealing about adding these ETFs to their portfolios?
MM: Core. They are long only indices designed to outperform the market in the longer term. ETFS Diversified-Factor Funds track indices that are specifically designed based on extensive time series and well established economic rationales focused on enhancing risk-adjusted returns compared to traditional market-cap weighted indices.
This approach should be of increased interest to investors whose performance is compared to traditional market-cap weighted benchmarks.
ETF Database: There are some out there who believe ETFs have gone too far from their initial intention of offering broad-based exposure to buy-and-hold investors. What’s your take on the innovation in the ETF industry over the last several years?
MM: The cost efficiency, flexibility and transparency of ETFs should continue to favor a migration of assets towards ETFs.
The Bottom Line
The recently launched SBUS and SBEU from ETF Securities warrant a closer look from anyone looking to steer clear of traditional cap-weighted equity funds given their numerous limitations.
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Disclosure: No positions at time of writing.