Today's investment world has seen a proliferation of index strategies and Exchange Traded Funds (ETFs). The investment objective of most ETFs is to replicate the returns of a particular index before fees and expenses using a fund investment approach commonly known as passive index management. The world's largest ETF is the SPDR S&P 500 ETF (symbol SPY). According to ETFdb.com, SPY has $270 billion of assets under management (AUM). The asset management fee for SPY is 0.095%, or 9.5 basis points, or equivalent to annual management fee income of $257 million for its owner State Street Global Advisors. SPY is nearly twice as large as the next largest ETF, the iShares S&P 500 ETF (IVV), with $142 billion of AUM. Vanguard offers a third ETF that tracks the S&P 500 that is ranked 5th in size at $84 billion in AUM. These three S&P 500 cap-weighted ETFs account for approximately 17% of the $3 trillion domestic ETF market.
The S&P 500 index is owned by Standard and Poor's and is widely regarded as the single best gauge of large capitalization U.S. equities. The index includes 500 leading companies, and because it is capitalization weighted (larger companies have greater index weight) it captures approximately 80% coverage of the available domestic stock market capitalization. Companies within each major industrial sector are represented in the index. The total market capitalization of the S&P 500 companies is about $22.6 trillion. Over $7.8 trillion (or 35% of the S&P 500's market capitalization) is benchmarked to the S&P 500 index. Passive index mutual funds and ETF assets comprise approximately $2.2 trillion (10% of market capitalization) of this total.
CNBC reports that U.S. ETFs took in $0.5 trillion in the twelve months ended May, 2017. A Bloomberg ETF analyst interviewed for this CNBC article noted that investment advisors and institutions have been actively switching their asset allocations to ETFs due a perception of enhanced liquidity and an overall lower cost of investment management. The Bloomberg analyst cited this cost factor as "the mother of all trends." The cost of investment management is an important consideration in an investment process but should not be the sole factor. Investors should also consider diversification benefits and expected returns relative to the risks for any investment strategy whether it's passive or active.
Another important trend cited in the article was that while ETFs saw net inflows of about $466 billion in the past twelve months through May, 2017, active mutual funds faced $350 billion in net outflows according to Bloomberg data. Passive index mutual funds also saw net inflows of about $200 billion in the same period - a winner in the passive versus active mutual fund race, but still a laggard relative to passive ETFs and their continued market share gains.
Investors appear to be moving to passive investment strategies en masse. This trend was affirmed in a global study of the ETF industry by EY entitled "Reshaping Around The Future - Global ETF Research 2017". The article concluded:
The growth of the ETF industry continues to defy superlatives. Global ETF assets, which totaled just $417 billion in 2005, had reached $4.4 trillion by the end of September 2017 — a cumulative average growth rate (CAGR) of around 21%.
It seems that almost every trend that has shaped investment markets in recent years has worked in favor of ETFs. This includes global themes such as the shift to self-directed retirement saving; economic factors such as low yields; regulatory efforts around suitability and value for money; technological developments such as digital distribution; and investment themes such as the “shift to passive.”
Supported by these factors, we expect the ETF industry to continue its rapid global expansion, outgrowing the wider asset management industry. The prevailing conditions remain favorable, and the industry retains its many innovative characteristics.
As the above chart depicts, 89% of $298 billion of net cash inflows into U.S. equity ETFs year-to-date through August 31, 2017 has flowed into traditional beta (market) ETFs, or capitalization weighted ETFs. The ETF industry has become a $4.4 trillion mammoth by providing investors with more efficient access to capital markets. This "mother of all trends" toward lower cost passive strategies will certainly provide investors with a lower cost of portfolio ownership, but it's important to also periodically evaluate what you actually own. Worries are growing among behavioral finance and other experts that by simply buying the SPY ETF, investors are pursuing a lemming-like crowd behavior which may have unintended consequences. Investors who automatically pour their lifesavings into ETFs that simply buy an entire market, like SPY ETF, may not pause periodically to prudently evaluate relative valuations and risks. I don't believe simply following the conventional wisdom of the crowd while wearing valuation and risk blinders is a prudent investment management approach.
Passive investors pursuing traditional passive capitalization weighted investment strategies may be sleepwalking their way toward another stock market bubble without recognizing the growing dangers. Richard Thaler, Nobel prize winning behavioral economics professor, recently cautioned investors about this potential risk: “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.”
A growing small minority of investors are moving away from these traditional market capitalization-based indices like the S&P 500 to alternative strategies, known as smart beta. Many are doing so in search of differentiated sources of excess return, or alpha, and for portfolio risk mitigation. As depicted in the chart above, smart beta (7.6%) and active ETFs (3.1%) represent only about 11% of the net cash inflows to U.S. equity ETFs.
Smart beta is a rather new term in modern investment parlance. Smart beta is a broad term for rules-based investment strategies that avoid the conventional market capitalization weightings that have often been criticized as fueling valuation extremes by systematically overweighting overvalued stocks and underweighting undervalued ones. Among the best known alternatives to market cap weighting are the fundamentally weighted indices developed by Research Affiliates (RA). RA ranks their index constituents by financial factors like book value, dividends, sales, and cash flow. Other RA smart beta indices are based on other factors such as momentum, volatility, or equal weighting. RA provides the following straightforward definition: "Smart beta strategies are designed to add value by systematically selecting, weighting, and rebalancing portfolio holdings on the basis of factors or characteristics other than market capitalization.(emphasis added)"
Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market capitalization weighted indices by using these alternative weighting regimes. Smart beta strategies offer the potential for better-than-market returns along with the traditional benefits of cap weighted passive index strategies of broad diversification, transparency, rules-based methodologies, and lower cost.
RA describes their process as follows:
Smart beta is a rules-based portfolio construction process. Traditional index-linked strategies rely on price to decide which stocks to invest in and how much of each to hold. But the stock market is not always efficient, so stock prices don’t always accurately reflect a company’s economic footprint. Smart beta strategies seek to exploit these market inefficiencies by anchoring on factors other than price. In other words, smart beta strategies break the link between price and portfolio weight in an effort to deliver better-than-market returns.
The stock picker for smart beta strategies is generally a rules-based algorithm or computer program.
Today, smart beta strategies are far from mainstream. Inflows to smart beta ETFs represent a small minority of the current annual pace of $0.5 trillion in cash flows into ETFs. Nevertheless, flows to smart beta ETFs have been growing rapidly over the past several years just as volatility has begun to wane as the chart above from Bloomberg depicts. Year to date cash flows to smart beta strategies approximate $3.5 billion.
Servant Financial model portfolios currently employ select smart beta ETFs - VanEck Vectors Morningstar Wide Moat ETF (MOAT), WisdomTree International Hedged Quality Dividend Growth ETF (IHDG), iShares Edge MSCI Minimum Volatility Emerging Markets ETF (EEMV), and VanEck Vectors Morningstar International Moat ETF (MOTI). The MOAT ETF has been in portfolios the longest. When we evaluated MOAT, we looked at the underlying index's historical performance track record relative to the S&P 500. For example for the 10 year period ended November 30, 2017, the MOAT index (includes performance prior to MOAT ETF launch in April, 2012) produced an annualized return of 13.1% compared to 8.3% return for the S&P 500 Index. We saw that MOAT had historically generated excess returns compared to the S&P 500 and that the related tracking error or variability of its returns relative to the S&P 500 seemed acceptable.
This fundamental approach used to evaluate MOAT is essentially the research process that RA has been applying on a grander scale and more research intensive manner to the various smart beta strategies and factors it follows. RA tracks seven broad strategies - value, income, low volatility, quality, momentum, multi-factor, and size - and eight factors across large and small caps - value (price to book), value composite, momentum, illiquidity, low beta, gross profitability, investment and size. You can learn more at their Smart Beta Interactive website.
Just like stocks, bonds, sectors and countries, smart beta strategies can become cheap or expensive over time. RA measures the relative valuations of their seven strategies versus market benchmarks to estimate how cheap or expensive a strategy is. Their relative valuation for equities is fundamentally based on the Shiller CAPE approach that RA applies to major equity asset classes that we've reviewed in previous newsletters. RA has found, like the Hussman Funds, that when relative valuation is low compared to its own history, that strategy is positioned to outperform. When valuation is high, it is likely to disappoint.
Much like RA's development of expected returns for each major asset class, the firm estimates a) an annualized expected excess return over the market benchmark (net of transaction costs) and b) the annualized expected tracking error relative to the benchmark for each smart beta strategy. The Smart Beta Interactive site transparently provides all this data to allow investors to conduct an informed return to risk evaluation of each strategy.
Since we're already a proponent of quality based smart beta strategies with the domestic and international moat ETFs, we were curious to review RA's interactive data on quality. RA's quality simulation selects companies from the U.S. Large and Mid Cap universe based on a quality score. The quality score combines high return on equity with low debt to equity and low earnings variability. Stocks are weighted by market cap times quality score and are rebalanced semi-annually. The following chart depicts the wealth growth of the quality strategy against the benchmark. Since 1968, this quality strategy has grown wealth approximately 1.8 times the benchmark.
On a forward-looking basis, the quality strategy is the most attractive of the smart beta strategies based on expected risk-adjusted returns. RA's expected annualized excess return over the benchmark is 3.59% for quality (net of trading costs of 3.26%) with an expected tracking error of 3.7%. This equates to an extraordinary information ratio of 0.97 (excess return over tracking error).
We also looked a RA's high dividend smart beta simulation given broad interest among investors for high yielding dividend strategies to replace fixed income securities and Servant's use of dividend-based IHDG in portfolio models. RA's high dividend simulation selects 100 stocks by dividend yield from the U.S. Large, Mid and Small Cap universe, after applying screens for dividend growth and dividend coverage. Stocks are weighted by indicated dividend yield and rebalanced annually.
Since 1968, RA's high dividend simulation has grown wealth over the benchmark at 2.2 times versus 1.8 times for quality. On a forward-looking basis, the high dividend strategy is less attractive on risk-adjusted return basis as compared to quality. RA's expected annualized excess return over the benchmark is larger at 4.50% (net of trading costs of 3.81%), but the expected tracking error is more than double at 8.6%. This equates to an information ratio that is almost half that of quality of 0.52 (excess return over tracking error).
We've provided this update on the ETF industry and an introduction to smart beta strategies in an effort to keep investors abreast of the strong undercurrents that passive investment strategies may be having on traditional capitalization weighted market indices. We continue to believe that market valuations are rich and are regularly evaluating relative values across asset classes and strategies. For example as we've written about previously, we see relatively attractive risk-adjusted returns in emerging market equites and debt, developed international equities, and the domestic biotechnology and healthcare sectors. We've recently spent research time on a multi-asset dividend yield portfolio model, and reinsurance and insurance sector fundamentals in light of the heavy catastrophe losses in 2017.
We've also seen firsthand that these systematic passive cap weighted money flows are creating significant inefficiencies in capital markets that nimble, contrarian investors are exploiting. Through our family office investment consulting engagement, we've witnessed active hedge fund managers hunting in inefficient pockets of the markets create extraordinary levels of excess returns, or alpha, in 2017 - a small cap technology focused manager posting mid-30% net returns and an international small cap manager posting mid-20% net returns. The iShares Russell 2000 Small-cap ETF (IWM) has produced a total return on a year-to-date basis of 15.1%.
We also conducted some initial research and development with an emerging investment platform that systematically screens market indices for industries/sectors subject to technological dislocation. I would broadly categorize this emerging platform as a "smart beta" strategy.
We will continue to evaluate the relative value of smart beta and other investment strategies to provide clients with more attractive risk-adjusted returns.