Institutions Favor Smart Beta ETFs

Terry Flanagan

One in four institutional investors report using smart beta ETFs, and adoption among non-users is likely to accelerate in the near future, according to a new study conducted by Cogent Research.

The results reveal that nearly half (46%) of institutional decision makers not currently using smart beta ETFs indicate they are likely to start using the products over the next three years, particularly institutional investors with assets in excess of $500 million.

Smart beta is an alternative index-based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both.

Within the smart beta ETF category, low volatility funds have experienced the greatest growth in 2013: a 99% increase in assets. This trend is expected to continue as two-thirds (67%) of institutional decision-makers not currently using smart beta ETFs indicate they are most likely to use low volatility funds moving forward.

In addition to low-volatility products, nearly half (46%) of non-smart beta ETF users anticipate using high dividend ETFs and over a third (34%) plan on using fundamentally weighted investment strategies.

“We have been seeing increased interest in smart beta ETFs with various institutional segments, and the research findings confirm that increasingly institutions are implementing smart beta ETFs,” said John Hoffman, Invesco PowerShares director of ETF institutional sales and capital markets. “Smart beta ETFs make a lot of sense for institutional investors seeking lower costs, intraday liquidity, increased transparency, ease of implementation, and strategies that go beyond market cap weighting.”

Non-users indicate that the primary drivers of future usage include making tactical adjustments to asset allocation (42%), accessing higher beta strategies (40%), portfolio completion (40%), and to reduce portfolio volatility (39%).

“We educate both users and non-users about the many benefits of PowerShares smart beta ETFs, and these results reinforce our belief that these products are great investment tools for institutional asset managers as well as retail investors,” said Dan Draper, Invesco PowerShares managing director of global ETFs. “We’re very excited about the future potential of our investment category.”

According to Cogent Research, smart beta gives institutional decision makers a middle-ground between actively-managed ETFs and those that are market-cap weighted. As a supplement to their investment strategies, smart beta ETFs are an effective tool for institutional investors and RIAs seeking better risk-adjusted returns and lower costs amid volatile market conditions.

While the growth is expected to continue in the smart beta ETF category, providers will need to take into account the primary drivers of adoption and address potential concerns. There is greater need for transparency and education regarding the composition of the fund, something ETF providers should be prepared for when positioning smart beta ETFs, according to Cogent Research.

Although Morningstar does not have a separate category for smart beta ETFs, they can be identified by their characteristics, such as using non-market-cap weighting or emphasizing less-traditional risk factors, according to Michael Rawson, ETF analyst at Morningstar.

Using a broad definition of the term, Morningstar counts 249 funds with the smart-beta theme with assets of $277.9 billion, up from $179.1 billion a year ago. Inflows of $46.0 billion in 2013 represent a 26% organic growth rate, faster than the 20% organic growth rate of U.S.-equity ETFs.

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