Separating True Innovation from Marketing Fads
More does not necessarily mean better. Last year, 157 new ETFs and ETNs were launched in the United States— one-tenth of the total of 1,546, according to ETF.com. But how many of these new funds can be called real “innovations”?
Take the hottest area of the market: what many investors call “smart beta,” “strategic beta” or “factor investing.” These are index strategies that take bets against the market in an attempt to either deliver risk-adjusted outperformance or to capture some particular factor approach.
There were 342 “smart beta” or, as Morningstar puts it, “strategic beta” ETP products with some $291 billion in assets available in the United States at the end of 2013. By our analysis, however, more than three-quarters of them follow strategies that in reality are tried and true methodologies.
For instance, more than 45 percent are split between traditional value-oriented and growth-oriented approaches, i.e., they divide a marketbased index down the middle (value/ growth) or in thirds (value/blend/growth). Another third is invested in funds that are screened or weighted based on dividends.
Those ideas have been around since the 1930s. There’s nothing necessarily wrong with them, but labeling them “innovation” stretches the true meaning of the word. They’re just a new way of accessing an old idea.
In this column, I will lay out criteria by which investors can separate the wheat from the chaff, evaluating new ETF offerings to determine what’s truly innovative and what’s a rehash. In a nutshell, investors must look to the underlying indexes on which these funds are based and determine whether they represent the latest fad or a sound, research-based way of approaching a defined segment of the equity market.
Criteria For Evaluating Innovation In ETFs
What represents a true innovation? I propose the following criteria to identify index innovations found in ETFs. To be considered innovative, an ETF or ETP must meet one or more of the following criteria:
Provides Access to Inaccessible or Costly Parts of the Market. ETFs have been critical in breaking new ground for investors. Some ETFs, for instance, provide investors with liquid, low-cost access to gold. In the equity world, ETFs have also been key in opening up emerging markets equities at low costs. Recently, things like the China A-share markets have been packaged into relatively low-cost ETF structures, providing investors with more options for exposure. These are real innovations.
Captures New Approaches to the Market. Growth and value concepts have been around for decades, as have strategies based around equity capitalization. But these “style box” factors do not explain all the things that influence security pricing. Recent innovations have provided investors access to other approaches to the market.
For example, the recent boom in low-volatility ETFs captured an idea that resonated with investors. Other innovative approaches replicate one or more individual factor indexes such as quality or momentum that have historically offered better risk-adjusted
Helps Investors See an Old Market in a New Way. Markets are always evolving, and there are times when investors may want to reassess how they view them. For example, some experts believe the increasing globalization of the economy makes classification of companies by country less relevant. A number of index providers have created new indexes that look at each company’s economic exposure—from where their revenues are derived—offering a truly new systematic way of viewing international equities.
Offers Better Risk-Adjusted Returns. An innovative ETF should provide better risk-adjusted returns, portfolio diversification or market representation. The ETF must improve an investor’s ability to track a given market, obtain desired exposures; reduce risk vis-à-vis the market-cap portfolio and/or increase returns; or lower costs. If your ETF cannot accomplish at least one of these goals, then why invest in it?
To be truly innovative, however, just launching products based on these new approaches isn’t actually enough. ETFs must also offer features and standards that reflect best practices in ETF and index construction, including:
Rules-based: Use an underlying index that is rules-based. Decisions related to constituents should not be arbitrary but should be understandable and should rely on publicly available information. Otherwise, decisions could be made that help the index provider but not the investor. For example, treatment of corporate actions should be clear and consistent, and any rebalancing of the portfolio should be regular and welldefined.
Transparent: Offer a high level of transparency. An innovative index should offer well-documented, predictable and clear rules. This practice enables: an investor to understand what she is investing in; the ETF manager to more easily replicate the index; and both to avoid relying on a list of stocks that may emerge from a “black box” model without true understanding. Transparency can also help avoid potential conflicts of interest, front-running by rival asset managers, or gaming of the rules that are not in investors’ self-interest.
Investable: The fund must have adequate capacity and liquidity. Without those features, an innovative strategy might lose its ability to add value at a relatively low threshold. A fund based on a strategy index may incur stiff transaction costs if it has to trade illiquid securities. In addition, the index should not be overly concentrated in a handful of securities, sectors or geographic areas. Overconcentration can impose undesirable risks. Lastly, turnover should be kept to a reasonable level or the trading costs may eat up a strategy’s added value.
Real innovation is a game changer. It starts with an idea that challenges the conventional wisdom; it finds opportunities where most see the status quo. But it also needs to work. Change for change’s sake can be costly and counterproductive. Innovation must allow investors to improve their investment experience through risk-adjusted returns, increased diversification, lower costs or market representation. Investors need to look for new and compelling ideas, but they must also be critical thinkers.