ETF Stream’s senior writer Tom Eckett speaks to Nutmeg’s director of ETF research James McManus on disliking the term ‘smart beta’, the reasons he does not invest in multi-factor ETFs and his concerns around the over-proliferation of factors in academic studies.
McManus joined Nutmeg as head of ETF research from Coutts in 2015 before being promoted to director in November. Prior to Coutts, he held roles at CreditSights as an associate and Citi Family Office as an investment analyst.
Tom Eckett: Do you use smart beta or factor products within your clients’ portfolios?
James McManus: We do use smart beta products, but I will start by saying we are not big fans of the term ‘smart beta’, primarily because I am not sure it helps investors understand the goal of the strategies. We use factor-based investment approaches, where we believe they can add value – either in terms of risk-adjusted return or diversification.
We do not seek to time factors, but rather, given that a component of our risk modelling for portfolios is factor-based, we feel we can use factor strategies over the long-term to neutralise biases or emphasise tilts in our asset allocation.
How much of your portfolios does smart beta typically make up?
Typically factor-focused products have only made up small parts of Nutmeg portfolios historically. We may look to increase exposure, but as our process revolves around active asset allocation, the extent to which we use factor products will always be driven by the extent to which we believe they meet the brief of our investment view.
We do not view individual factor exposures in isolation, we view them in the context of our wider portfolio positioning.
How do you view smart beta/factor-based ETFs?
Our portfolios are 100% ETF based so in a Nutmeg context, they are very much part of the passive toolkit. However, they are potentially very useful for assessment of active management performance, particularly against active managers who focus on particular styles of investing.
Investors are not paying enough attention to the source of actively managed returns in many cases, and the passing off of potentially structural performance linked to factor exposures as skill is still too prevalent.
Take the IA UK All Companies sector for example – in the ten years to end June 2019, performance of active managers against the FTSE All Share would appear highly correlated with performance of FTSE 250 against FTSE 100, with co-movement displayed in 85% of quarters. That is, when smaller companies outperformed larger companies, active managers outperformed the FTSE All Share and vice versa.
Investors in active funds should be seeking to understand how much of this performance is driven by the presence of factors such as size.
Which parts of the smart beta/factor-based spectrum interest you most at the moment?
One strategy we have used extensively in recent years is minimum volatility in emerging markets equities. We find this exposure interesting, not just because of the lower volatility basket of equities, but also the differentiated currency basket that comes with it.
The strategy is different in emerging markets than the US and Europe because you get this additional currency element too.
When you focus on a particular smart beta product to invest in what factors do you take into account?
First, we would only consider factor exposures where there is a straightforward economic rationale and a solid foundation to support a factor's existence.
Second, we extend this analysis to understand whether we believe the factor can be implemented efficiently in a long only context (as much of the academic support for factor investing comes via long-short studies).
The timing of factor investing would appear very difficult in our view, so any factor strategies deployed in portfolios tend to be longer-term positions.
We look at how ‘pure’ the factor exposure is – that is what additional factor biases are you potentially acquiring, positive and negative, along with your desired factor. We also look at where the factor is being driven from, in terms of holdings, sector exposures and so on.
Typically, we are then interested in what trade-offs need to be made versus the market cap exposure in order to implement the position, and that comes largely through additional cost. That cost could be higher management fees, but it will also be related to turnover levels and liquidity.
Historically, we have found factor products are much more expensive to trade than market cap, due to either higher hedging costs for market makers, and sometimes due to the need for creation, rather than sourcing units in the secondary market.
Alongside smart beta and factor-based investing, we have also seen the rise of thematic based investing using ETFs – does this interest you?
We have not bought into the thematic trend as yet. We find many of the products have limited track records, tend to be more concentrated and yet are often highly correlated to the performance of existing sector exposures, meaning the additional cost trade-off does not appear that attractive given the unknown volatility.
Some of the products that focus on trends or new technologies are certainly interesting to end investors, but much of these themes can be captured in more cost-effective ways and they are unlikely to be core holdings in asset allocation portfolios in the near term.
Are you concerned by the recurring accusations of hacking and data mining levelled at all factors and smart beta strategies?
It is important for anyone investing in factors to understand the underlying evidence of the factor’s existence, even if the reasons driving its existence can be debated.
We are acutely aware of the ‘factor zoo’ – the over proliferation of factors identified in studies, the over-reliance on backtests, and the false expectations this can create. To invest in a factor strategy you have to understand the limitations or constraints on the studies undertaken and have high conviction in an economic rationale for the factor’s existence.
It is also important to recognise how the factor is constructed and implemented relative to the study, what the potentially limiting factors are in that application and if there is reason to believe a given factor is more applicable to a given region or market segment (particularly in equities where sectoral differences influence regional market structure).
How do you engage with clients about smart beta?
Our client base is very diverse, so we receive a range of questions on our portfolio exposures – some complex and some less so.
Generally, our investors show a genuine interest in understanding their investment portfolios and will typically be less familiar with factor products.
Are there any specific areas where you would like to see new products emerge?
Fixed income factors should be interesting to investors in the same way that their equity counterparts are. Like factors observed in equity markets, there are several fixed-income factors that are well-documented and that have sensible economic rationales for existence.
There are also style factors that potentially read across from equity to fixed-income – for example, momentum or value.
So, the fact we have investable factor index strategies in equities but not in fixed-income at present in the European ETF market would seem an anomaly, and it is an area I am sure we will see more product development in the future given the products that have already been launched in the US.
Does multifactor investing interest you?
Not at the current time. We have generally found there to be a lack of consensus on the approach to weighting factors within a multi-factor approach and so have been relatively cautious in their application thus far.
By 2025 do you think you will be making extensive use of smart beta products and factor ETFs?
They are likely to be a larger part of core strategies than they are today. If you overlay ESG-focused strategies – and there is still active debate about sustainability factors given the differences in ESG definitions – then we will see core portfolios that use factors in a much more meaningful way, and investors who more commonly view their portfolios through the lens of factors.
Key to unlocking this though is investors having the right tools to analyse and identify factors within their portfolios, and to appropriately research factor strategies.
ETF providers in smart beta catch 22
A major inhibitor to growth has been a lack of ability for less institutional investors to appropriately analyse their existing exposures.
Investors are unlikely to add factor-focused investment strategies to their investment process without an ability to properly understand their starting point.
This article first appeared in the Q4 2019 edition of our new publication, Beyond Beta. To receive a full copy, click here.
To read the previous edition of '60 seconds with the buy-side' with Tilney's head of multi-asset Ben Seager-Scott, click here.