This article first appeared in ETF Insider, to read the full edition, click here.
Low tracking error, ‘index-plus’ active strategies that aim to outperform by assessing companies on fundamental metrics may bear a resemblance to Europe’s well-established smart beta ETFs.
Consequently, fund selectors must consider where these products fit within their portfolio construction and whether they align with their active or systematic investment objectives.
Total assets in smart beta ETFs reached €109.2bn in Q3 this year, now comprising 5.4% of all assets in the European ETF market, while active ETF assets rose to €45bn from €38.8bn in Q2, now accounting for 2.2% of total European ETF assets, according to data from Morningstar.
Comparisons arise between the two when Morningstar identified both JP Morgan Asset Management’s (JPMAM) research-enhanced ETFs and Fidelity’s research-driven equity strategies as employing “systematic” approaches.
In the report, titled Active ETFs in Europe: Small, Shy, and on the Rise, it states Fidelity’s active equity ETFs are “benchmark aware and systematic,” while JMPAM’s “incorporate its analysts' forward-looking fundamental ratings on stocks, but in a diversified and systematic fashion.”
“Systematic” might imply a rules-based, disciplined approach that applies consistent processes into the portfolio, reminiscent of smart beta strategies, rather than relying on subjective, high-conviction decisions.
Though, a counter argument can easily be made.
When comparing the iShares Edge MSCI USA Value Factor UCITS ETF (IUVL) with the JPM US Research Enhanced Index Equity (ESG) UCITS ETF (JREU) and the Fidelity Sustainable Research Enhanced US Equity UCITS ETF (FUSR) in terms of their valuation approaches, each demonstrates a slightly different methodology.
While all three ETFs integrate valuation metrics into their stock selection, their approaches differ. The iShares ETF relies on passive screening, using rigid valuation criteria - namely price-to-earnings and price-to-book ratios - to select attractively valued companies.
In contrast, JPMorgan and Fidelity take a more nuanced, research-driven approach, actively analysing companies to uncover those they believe are undervalued or hold intrinsic long-term value.
This topic opens up extensive discussion, and against this backdrop, ETF Stream spoke with three fund selectors to see how they are approaching the debate and where these products fit from a portfolio construction point of view.
Active versus systematic decision-making
One key area that sparks debate surrounds whether JPMAM’s and Fidelity’s ETFs are if they employ active or systemic decision making.
At the most basic level – and taking JREU as an example - decisions are actively made by JPMorgan analysts and portfolio managers, who apply fundamental research and subjective judgment on stock selection.
Smart beta strategies, on the other hand, follow predetermined, systematic rules based on academic research without portfolio manager discretion.
Peter Sleep, investment director at Callanish Capital, said JREU relies on fundamental research, analyst insights and a well-defined risk management framework. In contrast, he explained, commercial smart beta strategies are primarily grounded in academic research and may incorporate risk management depending on the strategy’s specific rules.
“The building blocks of smart beta are based on academic research by figures like Fama and French – small cap and value – Jegadeesh and Titman – momentum – and Robert Haugen –minimum variance.”
“I have read the research in the past and I do not think they put many constraints in their research to manage risk. The risk management was added by the industry because smart beta can be a have high tracking error”.
Meanwhile, Yvan Roduit, head of investment advisory at Raiffeisen, said JP Morgan’s extensive research capabilities lends itself more to active and deliberate decision-making surrounding stock selection rather than being systematic.
“That’s why it is difficult to label this as smart beta – it is really not. I think it is an efficient strategy in its own right,” he said.
Finally, a spokesperson from JPMAM said: “Our REI equity ETFs are actively managed ETFs which utilise best-in-class fundamental research to generate excess returns over time through bottom-up stock selection.”
What are the similarities?
Though ‘index-plus’ strategies may bear some resemblance to smart beta as they can display similar factor biases, the three fund selectors agreed that this does not make them smart beta strategies.
Both JREU and smart beta approaches may reflect similar factor tilts, such as a bias towards small-cap stocks or earnings growth.
However, Sleep said, “JREU almost certainly has a mild bias to small-cap stocks and earnings growth, but that does not mean it is smart beta. Nearly every active portfolio manager has this bias to small cap and about two-thirds load on earnings growth.”
‘Systematic’ techniques may be one other similarity between the two strategies, such as using an optimiser. Though, as Sleep points out, the optimiser does not equate to a set of rules to weight the stocks in the portfolio.
"If there is an optimiser involved, that is fine. An optimiser is there to balance portfolio risk or tracking error and analyst conviction.”
James Penny, chief investment officer at TAM Asset Management, added the dependability of the strategies in terms of performance and risk means that “one would be forgiven for placing it in or near the enhanced beta range.”
‘The modern version of smart beta’
Zooming out, Penny and Roduit both agreed that the draw of JPMAM’s ‘index-plus’ strategies lie in their ease of scalability, with Yvan adding you can also expect alpha at a low cost.
“It is very straightforward to explain: this is the strategy, how it works, and what the expectations are and that is it.” Ultimately, active ETFs – namely ‘index-plus’ strategies are the “modern version of smart beta,” said Roduit.
“They are smarter and with limitless potential for evolution."
