Understanding ETF Trends: Smart Beta, Hedged Equity and Bespoke ETFs – Caveat Emptor

Understanding ETF Trends: Smart Beta, Hedged Equity and Bespoke ETFs  – Caveat Emptor

A June 4th report from FactSet Insight focuses on three major themes in the ETF sector. FactSet Director of Exchange Traded Funds Dave Nadig explains what Smart Beta, Hedged Equity and Bespoke ETFs mean and whether you should consider them for your investment portfolio.

Is Smart Beta really that smart?

Smart Beta basically means investing in something besides the total market and weighting your stocks by anything other than market cap. This kind of a broad definition means all sorts of funds are Smart Beta funds. Like investing based on low P/Es? Smart Beta. It’s the same for growth investing, equal weighting, or even price weighting (like the Dow Jones Industrial Average).

Nadig points out that these “smart and kind-of-smart ETFs have become a driving force in the ETF industry. We count some 811 funds out of the 1,796 ETFs currently on the market as Smart Beta, with nearly 25% of total assets ($526 Billion) falling into this category.”

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However, not all Smart Beta funds deliver the goods in terms of returns. For example, Value and Growth almost never both work at the same time, but they are are considered basic Smart Beta. That’s why the ETF industry has been working hard to develop multi-factor Smart Beta ETFs that apply more than single factors to select stocks. However, as of June 1st, there were 42 multi-factor ETFs with five-year track records, and only eight showed any statistically significant alpha, and three of the eight were negative alphas.

Given these results, Nadig suggests “investors would be wise to approach them with watchfulness and a healthy dose of skepticism.” As Josh Brown of TRB notes in an insightful and humorous article titled “Competition to Launch the Most Complicated ETF Heats Up”

A few years ago, the blogosphere mocked the launches of such nonsensical products as the “global aquaculture ETF” – literally an index of publicly traded fish hatcheries. Then the triple-leveraged gold mining ETFs and the triple biotech ETFs came along and we barely sniffed at them. By the time they were rolling out such absurdities asthe “Risk-On” and “Risk-Off” products (ticker symbols were ONN and OFF, natch), the bloggers couldn’t even get up the dander to spit in the issuer’s general direction. Both were eventually killed in May of last year, with very few investor tears shed at the announcement.

The new phase involves currency-hedging every asset class in sight as well as 800 different ways to do smart beta.


Hedged Equity strategy

Hedged equity is a specific Smart Beta strategy that just invests in international equities while setting up currency forwards to remove the implied long position in the underlying currency.

Timing is everything, and the last three years have seen the hedged yen trade go on a historic run. Nadif notes: “The combination of a roaring equity market and a rapidly devaluing currency made the bet, which hedged exposure to the yen, one of the trades of a lifetime. Investors who caught the train early have had three-year returns of over 240% (75% above their unhedged counterparts).”

The Hedged Equity strategy also worked like a charm in markets where the strong dollar ruled and the cost of hedging was low. Nadig explains: “The cost of hedging the dollar is cheap if the prevailing interest rate for the dollar is equal to or higher than the interest rate of the target currency. This has made the euro and the yen—where zero interest rates rule the day—ground zero for currency hedging arrangements.”

Keep in mind that currency-hedged ETFs were a tiny segment just three or four years ago, and today there’s more than $62 billion invested in currency-hedged ETFs. Moreover, close to $35 billion of that total has flowed in over the last six months.

Never-ending stream of bespoke ETFs

The ETF market has become so large that ETFs are replacing structured products as the vehicles of choice for unique exposures. This has led to a slew of highly varied “bespoke ETFs.”

The trend began back in 2013, when Blackrock got together with the Arizona State Retirement System. ASRS was looking for exposure to the MSCI “Quality Mix”, a Smart Beta index designed to replicate Warren Buffett’s holdings at a low cost. They set up to create a custom iShares ETF (QUAL) to house the MSCI index.

ASRS launched the new ETF with more than $100 million compared to just $5 or $10 million most ETFs start with. It worked like a charm, and QUAL now has more than $1.1 billion in assets. Moreover, QUAL’s success has spawned a legion of new custom ETFs.

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