ETFs get active, but come with hidden risks

The increasingly volatile trading climate, in which daily swings of 1 per cent or more are becoming commonplace, is creating the perfect opportunity for ETFs that don’t just blindly invest across entire market indices.

Instead, these products are being structured in a way to reduce market volatility by only investing in stocks within an index that meet very specific investment criteria, such as those matching a predetermined level of sales, cash flow, book value or dividend payments. Companies that don’t meet the criteria are automatically filtered out.

Other common factors being used are quality (financially healthy companies), value (stocks trading at a discount), momentum (stocks with upward price trends), and volatility (stocks with lower volatility characteristics).

By sorting the proverbial investment wheat from the chaff, investment managers are hoping investors will latch on to the concept and use these factor-based ETFs, sometimes known as smart beta products, as another tool within their portfolio arsenal.

Retail demand picks up

It’s working too, with total assets within factor ETFs topping $US1 trillion globally at the end of 2017. Australian investors want the benefits of an index fund with an actively managed hand on the rudder, and are demanding more smart beta fund options.

Which is why, just in the past couple of weeks, both Vanguard and VanEck — two major players in the global ETFs space — have launched actively managed funds on the Australian Securities Exchange based on different factors.

Vanguard launched two funds: Global Value Equity (VVLU) and Global Minimum Volatility (VMIN), which are respectively seeking to achieve specific risk and return objectives through factor exposures towards global value and global minimum volatility. “Factors are the DNA of an investment portfolio; the underlying characteristics that drive investment performance,” says Michael Roach, the Australian head of Vanguard’s Quantitative Equity Group.

“Vanguard is taking a different approach to other factor fund ­offerings in the market — we are actively managing these portfolios, weighting shares according to their exposure to each factor while maintaining a broadly diversified investment portfolio.”

Meanwhile, VanEck launched a Multifactor Emerging Markets Equity ETF (EMKT), which is based on the MSCI Emerging Markets Index but which filters out stocks that don’t meet its quality, value, momentum and size ­criteria. “Emerging markets is currently one of the most attractive asset classes, with emerging markets stocks trading at a significant discount to developed markets,” says VanEck managing director Arian Neiron.

“Long-term trends too favour emerging markets. Emerging market nations account for almost 60 per cent of the world’s population and account for an increasing proportion of global GDP, yet emerging market securities account for less than 10 per cent of all equity funds’ holdings. Fund managers around the world are recognising the investment opportunity that these securities represent given their attractive prices and growth prospects.”

Expect more factor-based ETFs to hit the Australian product shelves over coming months, with other industry heavyweights such as BlackRock, State Street and BetaShares all wanting a slice of the lucrative smart beta pie.

Investors need to be aware that factor investing — which is fundamentally designed to reduce risk — does carry inherent risks.

A study released last month by US-based firm Scientific Beta found that these risks can have a significant impact on portfolio performance.

“Although gaining explicit exposure to priced risk factors is expected to provide good long-term risk-adjusted performance, investing in these factors also exposes investors to several non-priced risks that could be important drivers of short-term risk performance,” said ERI Scientific Beta chief Noel Amenc.

In other words, the very factors that some funds are using to reduce their risk could become threats instead of opportunities.

For example, depending the factors chosen by an investment manager, investors could be unduly exposed to shorter-term risk factors including broad downward shifts in markets associated with macroeconomic, sector and geopolitical situations (think the US-China trade war and heightened tensions in the Middle East).

Paul Bouchey, chief investment officer at the Seattle-based funds management group Parametric, has been advising Australian super funds around the use of factor-based ETF products. “A lot of times these smart beta indexes or factor strategies come along with unintended bets. If you don’t manage those unintended bets, they can really be a pitfall and a big risk,” Bouchey says.

The way around this, he says, is to build in constraints around the investment processes, such as by imposing some sector diversification on the stock selection process. “We believe constraints are a critical part of the investment process, as they reduce the noise and amplify the signal for factor-based strategies, which can help you avoid the unintended pitfalls.”

Factor-based products can help to reduce risk and volatility, but keep in mind that different factor variables can have the opposite effect over the short term if unforeseen events arise.