Sep­a­rat­ing True In­no­va­tion from Mar­ket­ing Fads

Enterprise - - Contents - By P. Brett Ham­mond

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

re­turns.

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.

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