Ask the expert: Strategic beta ETFs

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<p><strong>Glenn Freeman</strong>: In this edition of "Ask the Expert" I'm speaking to Thomas Reif from State Street.</p> <p>Thomas, thank you for your time today.</p> <p><strong>Thomas Reif</strong>: Good morning, Glenn. Thank you.</p> <p>Freeman: Now, we are discussing smart beta or strategic beta as it's called or even active beta. I suppose obvious stating point is to explain what strategic beta is and why is it important, why do investors need to know about this?</p> <p><strong>Reif</strong>: Strategic beta portfolios are designed to target particular factors in the market that drive excess returns. So, they are an active way to harness &ndash; so, they are a portfolio that can harness active expected returns at a low cost.</p> <p><strong>Freeman</strong>: I know the generic or exchange-traded funds sector is valued at around $40 billion and the strategic beta is a subset of that, but it's still growing at quite a substantial rate.</p> <p><strong>Reif</strong>: It's growing at a very fast rate. So, we've got a lot of popularity, particularly among the retirees that can seek some high-yielding ETFs such as WDIV or SYI being global high-yielding ETFs. And there's a lot of interest now in sort of our low-vol &ndash; our Quality Mix Fund which targets sort of low volatility cum high quality and value.</p> <p><strong>Freeman</strong>: Yeah. So, around one-third of the ETF products that are out there in the Australian market are strategic beta. How big a subset of your product mix within State Street?</p> <p><strong>Reif</strong>: Look, by account, it's probably about the same, maybe sort of 20%, 30%. We have some ETFs that target high yield as well as ETFs that target a bunch of strategic factors to give a particular return profile, as well as the core of our index products, just the ASX 200 and the 50 and the (LPT) strategies, of course.</p> <p><strong>Freeman</strong>: And when you are talking about factors, what do you mean in this context?</p> <p><strong>Reif</strong>: Factors are a handful of variables that have been shown to drive returns in the long term. And they can be whittled down to value, size, low volatility, high quality and even high yield. These are characteristics of the stocks that have been shown to drive excess return in the long term.</p> <p><strong>Freeman</strong>: Is it predominantly within the Australian market that you look out for these products? Or you have these smart beta also looking at some of the global stocks?</p> <p><strong>Reif</strong>: We run these particular strategies from all of our portfolio management offices in the world, but in particular the investment universe of the strategies also are global. So, it's a highly diversified strategy that targets these factors across global markets. And indeed, in the research that supports these strategies, they have been tested across multiple markets over long timeframes to show that these excess returns exist in the long-term.</p> <p><strong>Freeman</strong>: And how large are they? In terms of the number of stocks that underpin these products, how many companies typically are within them?</p> <p><strong>Reif</strong>: The Quality Mix strategy in Australia has in the order of 500 securities that it's invested in any point in time and its fund size is between sort of $5 million to $50 million mark.</p> <p><strong>Freeman</strong>: How does that vary across the different tranches that you are talking about in the quality, the low volatility, for instance?</p> <p><strong>Reif</strong>: The Quality Mix Fund is combined by taking equal-weighted thirds of each of the individual smart beta factors of strong value, high-quality and low volatility. The underlying components have a varying number of names. The quality sleeve has about 300 names. The value sleeve has 1,500 names and the low volatility sleeve, I think, has about 500 names. But when you combine those to form the Quality Mix portfolio, some of those trades are too small to implement cost effectively. So, the Quality Mix Fund implements a subset of the target names to be efficient in implementation. And as the strategy grows, it's set to well diversification.</p> <p><strong>Freeman</strong>: And how well have these products performed in, say, a relatively low-return environment? And how well have they been tested in a downturn?</p> <p><strong>Reif</strong>: Look, the testing that underpins these strategies goes back to as long as data can be found for. Say, the value sleeve, so that goes back at least 70 years. Each of the individual sleeves are tested on at least 20 years of data. This strategy has been around for three years, the Quality Mix Fund, in the Australian market and we tend to find that it outperforms more often in down markets relative to &ndash; performs relatively strongly in down markets. It still participates in upside when markets run. But that can be a period when you expect it to lag a little bit &ndash; lag the market a little bit.</p> <p><strong>Freeman</strong>: What are the reasons behind that, that outperformance that you get from these smart beta products during a downturn?</p> <p><strong>Reif</strong>: Glenn, the strategy has been engineered to have that sort of performance profile and the way that we achieve that is by two-thirds of the factor inputs being the low volatility and high quality factors. And both of those components tend to do well in down markets. For instance, when the markets, in a downturn they tend to get more focused on forward-looking earnings and the high-quality companies have more clarity on their forward earnings as well as a lower level of debt. So, when the market goes in downturn, these companies are more comfortable in their cash buffer and tend to outperform. Likewise, low volatility companies are low volatility because they have more certainty with regarding their forward earnings. So, in times of market downturn, when investors are trying to avoid uncertainty, you find low volatility names also outperform. And those two components form the backbone of the Quality Mix strategy, but then it's augmented with the value sleeve which allows some upside participation when markets run.</p>

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