A recent EDHEC-Risk Institute study reveals some interesting trends in the adoption of smart beta ETFs in Europe.
The study found that, in addition to a high rate of usage and satisfaction of ETFs in general, smart beta indices (i.e., indices that are not cap-weighted) are used by 28% of current investors, while another 36% are considering “investing in such products in the near future.” Doing the math, we should expect that more than half of European investors will soon be utilizing smart beta strategies.
Can this trend among European investors be extrapolated to U.S. DC investors? Let’s consider the rationales given by the study’s respondents for embracing smart beta:
• It is a tool for improving their investment process.
• It provides significant potential to out-perform cap-weighted indices in the long term.
• Diversification across several weighted methodologies allows risk to be reduced and adds value.
• It allows factor risk premia, such as value and small-cap, to be captured.
In the U.S. defined contribution space, smart beta has not had nearly this big an impact. However, for all of the reasons listed by the European respondents in the study, DC plans ought to at least consider adding smart beta strategies to their fund lineups, especially in the allocation constructs (e.g., target-risk or target-date).
The challenge for many plan advisors is that, at least when it comes to DC plans, most advisors and plan sponsors still think in a binary fashion — that is, active verse passive, with the latter nearly always meaning “cap-weighted indices.” Often, the middle ground between the two — smart beta — is not even part of the discussion.
There are two main reasons why DC plans have been slow to adopt smart beta indices:
• Vanguard, which recently passed Fidelity in total DC assets under management, is primarily focused on cap-weighted indices and has effectively set the standard in the DC space for what is truly passive.
• With the exception of a few firms such as Dimensional Fund Advisors, the growth of smart beta has not been in mutual funds, but in ETF vehicles such as the “factor ETFs” being deployed by BlackRock’s iShares.
As reported in last week’s post, Schwab (selling direct) and TD Ameritrade (selling through advisors) are just now beginning to gain traction in the DC space. However, the vast majority of DC record keepers (on a participant-weighted basis) still will not administer ETFs outside of some type of wrap vehicle (e.g., collective investment trusts).
Conclusion
The need for diversification only grows as the market continues to hit new highs and many plan advisors are waiting for the other shoe to fall. The question is not whether there will be some type of major market contraction in the future, but when. There seems to be little doubt that diversification can be enhanced through the use of non-cap-weighted indices, especially given the high concentration in cap-weighted indices. That being the case, plan advisors, for all the reasons listed by the respondents of the EDHEC-Risk Institute study, should consider smart beta alternatives and not wait for ETFs to be offered through recordkeepers. This requires seeking out smart beta indices in the mutual fund industry or including smart beta ETFs in CITs that serve as asset allocation constructs.
