Terrorism, Brexit, worries about banking stability. Plenty of these and other factors have been generating volatility in European financial markets in recent months. But one market sector has thrived amid the turbulence: smart beta exchange-traded funds.
European investors are rushing to these factor-based ETFs, and low-volatility funds are among the most popular. The BlackRock iShares Edge S&P 500 Minimum Volatility ETF registered inflows of €200 million ($220 million) in May, the most that month of any smart beta ETF, according to a recent report from Ari Rajendra, a strategist at Deutsche Bank in London.
Recent high levels of volatility in equity markets “have been particularly favorable for minimum-volatility strategies,” says Manuela Sperandeo, BlackRock’s head of specialist sales for Europe, the Middle East and Africa. Minimum volatility was one of the first smart beta strategies iShares launched, she says, so investors have had time to grow comfortable with it, “to observe the performance and really monitor the behavior in different market conditions.”
Smart beta ETFs, which track some factor-based index rather than a traditional market capitalization index, have taken the investing world by storm in recent years, and although European investors came late to the party, they are catching up fast. European investors accounted for just under $21 billion of the $230 billion global market for such products at the end of September 2015, according to BlackRock, but the region is enjoying the strongest growth. Inflows into smart beta ETFs ran at an annual rate of 40 percent in Europe between January 2012 and September 2015, the firm found, compared with growth rates of about 30 percent in Asia and 25 percent in the U.S.
Smart beta ETFs pulled in a total of €1.2 billion in June and more than €4 billion in the first six months of the year, according to Deutsche Bank. A recent survey by FTSE Russell, the London-based index provider whose products are used by growing numbers of smart beta ETFs, found that 52 percent of European asset owners surveyed were using such products, compared with 28 percent in North America and 38 percent in Asia-Pacific.
There has been a move toward low-cost passive strategies in general, says Martin Weithofer, head of strategic beta at Deutsche Asset Management in Frankfurt, and investors see “the potential for improved risk-adjusted portfolio performance with the strategic beta approach.”
Deutsche is particularly enthusiastic about the potential for smart beta in the fixed-income space, as many investors are seeking alternatives to classic market capitalization–based indexes, which by definition are weighted toward the most indebted issuers. The firm recently launched a new ETF based on the Markit iBoxx USD Emerging Sovereigns Quality Weighted index, which grades sovereign issuers on a number of measures such as the inflation rate, history of default and sovereign debt as a proportion of gross domestic product.
Vanguard Group, the U.S. passive investing giant, launched its first four smart beta ETFs — focusing on minimum volatility, value, momentum and liquidity — in Europe last December, hoping to capitalize on the booming market. “We seem to be lagging the U.S., but if you look at the trajectory, we would expect things to evolve here in a way that they did there,” says Mark Fitzgerald, the firm’s head of product, Europe. “It’s just they’re a few years ahead of us.” The majority of investors are institutional, he adds, although the balance could swing as the retail market matures.
Adam Laird, head of passive investing at Hargreaves Lansdown, a U.K. financial firm that works mainly with individual investors, says they have shown a good appetite for products in the equity income space, which invest in shares but aim to provide greater income than broad-based market indexes. “It started off very much about institutions, but Hargreaves clients, who are mostly individuals, are doing more and more in this area,” he says.
Some analysts and investors worry that the rush of money into smart beta products could erode the market opportunities the products aim to exploit. Acknowledging the potential concern, Sperandeo says BlackRock seeks out factors that capture sustainable factors or “behavioral anomalies that have influenced the outperformance of low-volatility stocks vis-à-vis their riskier counterparts.”
Laird points out the relative complexity of many smart beta ETFs, which could make it difficult for retail investors “to understand where that risk is coming from and when it might hurt them.” Still, these problems aren’t unique to smart beta, he says.
“They’re just issues that investors need to be aware of, and I don’t think that they’re going to stop these new products,” he says. “It’s just the same old lesson: Make sure that you know what you’re investing in, and you know how it works for you, and spend the time to choose the right investment.”
