Practical analysis for investment professionals
10 May 2018

ETFs and Smart Beta: From Invisible Hand to Invisible Octopus

ETF.com managing director Dave Nadig is one of the most prolific thought leaders in exchange-traded funds (ETFs). Indeed, at Barclays Global Investors, he was instrumental in the development of some of the earliest ETFs.

Nadig will be speaking at the Inside Smart Beta & Active ETFs Summit on 6– 7 June 2018 in New York City, where he will join smart beta pioneer Rob Arnott of Research Affiliates, among other luminaries, to assess what the future looks like for these investment vehicles.

Given the rapid growth of ETFs and smart beta, we wanted to get Nadig’s perspective on the evolution of these instruments as well as the criticism they have evoked. Below is a lightly edited transcript of our conversation.

CFA Institute: To kick us off, let’s zoom out to another great thinker — Adam Smith. Why go all the way back to the invisible hand? Well, Rob Arnott of Research Affiliates is widely credited with inventing smart beta. Proudly displayed in Arnott’s’s lobby is a 240-year-old first edition of The Wealth of Nations. So, what do you think the great Scotsman would say about the role of exchange-traded funds (ETFs) and smart beta in the markets?

Dave Nadig: I think the most positive spin you could put on it would be that all of the focus on factors is really an invisible octopus, instead of an invisible hand. If we have market forces pushing prices around based on supply and demand, that’s the traditional invisible hand description.

All the breaking markets down into various factors is doing is saying, “Well, we have multiple influential hands here. We have people pushing growth versus value, and people pushing small versus large, etc., etc.” I think that’s the nicest way you could interpret that.

It’s reasonable for people to be careful about smart beta, about factor investing, just as people are skeptical about asset management. At the end of the day, market performance is market performance.

Ultimately, all of the actors in the market, whether they’re factor investors, single stock pickers, or blind buy-everything indexers, are all participating in that price discovery for a market performance. There’s just no way around that. That’s the mathematical proof. Factors are just one more way of teasing out performance variance from that market line.

Invisible octopus, that’s a new animal! Indeed, some say that smart beta is a unique beast — as in “This time is different.” It’s rules‑based. Behavioral follies that trip up poor irrational investors have finally been defeated! Rules trump human biases. Is rules‑based always a feature? What about the naysayers, like Steven Bregman, who say it’s a bug?

First of all, I don’t think there’s actually much to the argument that somehow, this time is different, when it comes to factors or when it comes to smart beta. People have been doing this kind of factor investing for multiple decades at this point.

I think if people want to be skeptical, be skeptical of claims that somehow a black box is going to consistently deliver risk‑adjusted outperformance in all markets. I don’t believe that. I don’t actually know very many academic finance people who believe that.

If you were looking at smart beta to be that magic bullet that provides you that risk‑adjusted outperformance in all markets, I think you will be sorely disappointed. I do not believe that there is a magical box that you can run market data through that generates that consistently outperforming portfolio.

That doesn’t mean that smart beta is a bad idea. It means that smart beta is a toolbox to generate certain kinds of performance in certain kinds of market conditions. I think that that’s actually valuable.

Skeptically useful then! Okay let’s give skeptics the floor first, before we switch back to the smart beta supporters. In August 2016, venerable Sanford C. Bernstein asserted that smart beta may be the silent road to serfdom. A clever, Friedrich Hayek-inspired headline for sure. But I suspect you don’t wholly agree with that finding?

First, let me remind everyone that the Bernstein report was a takedown on indexing, not on smart beta. The core argument there was that indexing and passive investment in general was a poor allocator of capital in an economic system.

Therefore, we were effectively worse off than we would be in Marxism, because at least there there was some hope that an intelligent human was making decisions about capital allocation. If smart beta is an extension of that, sure.

Ultimately, I would argue that a smart beta process probably has more impact on price discovery than a flat, buy‑everything indexing strategy. If the alternatives for price discovery are all the money chases the Russell 3000s, or there are 25 different smart beta approaches, some of which weigh heavily on value, growth, size, etc. All of those things are in the market together, and people are, in fact, voting on their opinions by which smart beta product they’re buying, that actually enhances price discovery.

As you point out passive indexing, ETFs, and smart beta are not all synonyms. Someone who knows a thing or two about this space is Vanguard’s founder, the legendary Jack Bogle, who has pointed out that ETFs may contribute a great deal to market fragility.

I tend not to buy that. Bogle’s arguments really come down to two cases. One is, he argues that because intraday liquidity becomes available to investors through ETFs, that they therefore will trade, and they will therefore do worse off.

Now, there’s a lot of if‑thens in that logic. If you believe that people will naturally walk into the tiger pit when you put it in front of them, and there’s no way to train them not to, there’s no way to help them understand the patterns around them, then sure.

It’s a pretty negative and depressing view of investor behavior and human nature. But by that token, we should outlaw all professional investing. People should just give all their money to the government.

I think there are some flaws in that thinking, that simply because a product exists, investor behavior will drive people to ruin. There’s a second set of questions around ETFs from a structural standpoint, and where they fit in several pieces of pie.

I’ll let you decide which one you want to go for here. I think there are questions around where ETFs help or hurt the price-discovery process. I think there’s questions about whether ETFs help or hurt the capital-allocation process, which is tied into that.

Then there are structural issues around: Do ETFs pose some sort of existential threat to the way the equity markets themselves are functioning? Is there some sort of bugaboo in the way the products are structured that breaks markets?

I’m happy to wade into any one of those, but I’ll let you pick which one you want to chase first.

Handing retirement savings to the government doesn’t seem to be the answer either — just look at US Social Security. So markets functioning properly seems to me to be our best bet. With this in mind, let’s talk ETFs and market integrity.

Fundamentally, I just don’t buy that this derivatively priced vehicle, which is fundamentally just a pooling vehicle — like a mutual fund, which we’ve been trading since the 1400s — that that somehow breaks the structure of the market.

Now, I’m not putting my head in the sand and suggesting we haven’t had instances like the August 24th [2015] or the May 2010 flash crash, where we’ve had price dislocations in the market to trade for the ETFs themselves.

Those things can happen in any security. We have price dislocations in Apple stock. We get price dislocations in IPOs. It is, I think, a noble and societal good to try to minimize those sorts of short-term price dislocations in any asset, because they tend not to be functional and useful in a capitalist society.

Yes, by all means, we should minimize those price dislocations. In fact, what happened after May 10th and August 24th was that the exchanges themselves came up with a system to effectively minimize those, whether the traded security happens to be an ETF or it happens to be a stock.

Now, the reason we tend to pay attention to it when it’s an ETF is because usually there is a benchmark where you can say whether that price is “fair” versus benchmark. If the S&P 500 ETF trades down 5%, but the S&P stocks are flat, we can look at that and say, “Aha! We have a price dislocation. Something is wrong.”

Now, that disconnect between a “fair” value and the traded value is something we have an entire arbitrage system in place to fix, and it actually performs beautifully. We just went through one of the most volatile periods we’ve seen in recent history, where, in fact, we had huge redemptions in some corners of the market.

It went unnoticed, but in the midst of the minor VIX spike, we had a billion‑dollar redemption in a corporate ETF. A billion dollars in one day. A billion dollars in corporate bonds is a lot. That whole market only trades $30 billion on a good day.

Yet there’s no impact on spreads. There was no hiccups in price discovery whatsoever. Everything worked beautifully in the most chaotic day we’ve seen in years. The structure itself, I actually think, is a boon that is helping the price-discovery process and is helping investors get liquidity where they otherwise might not have access to it.

I tend to just dismiss those concerns.

Now that we’ve established that smart beta will not destroy the investment world as we know it, what portfolio implementation questions should investors be asking?

I think as investors, we’ve gotten comfortable with asking “smart beta” products to do certain things, to the point where we don’t even necessarily talk about, say, the Russell 2000 being a smart beta product. It’s just a small-cap index.

There’s really fundamentally no difference between investing based on size, investing based on value, investing based on momentum, quality, or a balance sheet metric. You are taking some factor of the market, and saying, “Ah, there is a different pattern of performance over here. I would like some of that,” for whatever reason you may have as an investor.

Part of what we’re dealing with, I think, is almost a bit of a generation gap, where those of us who are a little older, and have been in these markets for a long time, look at traditional size and style metrics, like growth, value, large-cap, small-cap, and we’re very comfortable with that. We’re very comfortable saying, “Hey, you know what? I feel like we’re in a small business boom cycle. I feel like we’ve had a little bit of an overrun at the top of the S&P 500. I’m going to allocate a little bit more down into the small-cap market, because I, as an investor, have a fundamental belief that they will, if not outperform, provide some risk reduction on my overall equity portfolio.”

We don’t think of that as a smart beta conversation, but fundamentally it is absolutely no different than saying, “You know what? I think we’re going into a market where low-volatility stocks are going to be rewarded.”

It’s actually the exact same conversation. We’re just talking about a different factor. I think a lot of this comes down to really the language we use, and the generation of investor that has been brought up with certain factors being “normal.”

How much attention — and you’ve alluded to that — do we need to pay to the impact of the language of smart beta on the investor’s behavior?

I think it is a question a bit of diminishing returns. I think a legitimate question about the smart beta and factor investing renaissance, if you will, that we’ve been seeing is: At what point are we simply replicating factors we already have, or slicing the market so thinly that the factors don’t have much explanatory value in our portfolios?

I think we can all look at the data and say, “Hey, you know what? There really is a difference between, say, small cap and large cap.” We can look at the difference between high price to book and low price to book stocks in different markets and say, “Hey, you know what? These things actually do have predictive value in certain market conditions.”

I think it is true that as you start going into more and more esoteric factors, that explanatory power starts to diminish. At which point, I think it’s reasonable to say, “Look, how many factors do I really need to be considering here? Do I need 100 multifactor portfolio, versus, say, two or three?”

I think those are legitimate concerns. Unfortunately, what it does is it puts an enormous onus back on the investor to be a quasi‑academic, and start answering those questions for themselves. There’s no question smart beta has been a bit flavor of the week for the last two or three years. There’s a lot of marketing spend.

ETFs are certainly a flavor of the month. When they’re seeing active managers voting with their dollars by launching ETFs, what does that tell you?

We actually haven’t seen a huge rash of true active funds. What we’ve seen is some folks with big active shops launching smart beta products along the side. What that says to me is they’re trying to replicate processes that they have internally using a methodology that doesn’t require them to expose individual stock choices.

They’re doing that because they don’t like the transparency of the traditional ETF wrapper. There are a few exceptions — Davis Advisors comes to mind — where they’ve taken their process and just completely opened it up.

You can see every trade every day. They’re happy to talk to you about what they own and why they own it. That’s really an outlier. Most of the active stock‑picking community have not wanted to wade in on ETFs while there’s this requirement that they show their whole portfolio.

Even the larger firms that have main acquisitions have launched funds that are known more as traditional asset managers, or have the asset management shops, haven’t been willing to wade in. You look at something like Janus, where Janus bought an ETF provider — VelocityShares in that case — and then launched a series of products. They didn’t wade in with the Janus 20. They didn’t wade in with their flagship products.

Do you think that’s likely to change? Is there a catalyst that you are watching out for?

There are several proposals that have been in front of the SEC for quite some time around running non‑transparent, or less-transparent ETFs, and actively managed ETFs. I do suspect that one or more of those structures will eventually be approved.

I think that will open a floodgate for a lot of these active managers to bring product to market that is less or non‑transparent, where they’re not showing their whole portfolio every day. That’s been the big bugaboo. That’s been the thing that’s been keeping them from entering the market in as much force as I think they would like to. I think that’s probably the big hook. Absent that, I think you’ll continue to see what you’ve seen, which is a lot of active managers getting their feet wet, but not willing to fully commit.

This has been a very insightful discussion. I think it’s fair to say that skeptics and enthusiastic supporters alike need to deepen their knowledge of smart beta ETFs. This means asking experts such as yourself. You recently launched the “Ask the Chump” online Q&A series. Self deprecation aside, did the investor-raised themes surprise you?

That feature, which is a live chat session where people can just pester me with whatever they want, we’ve been doing it for a few months now. I think the thing that I find most surprising is the breadth of questions.

We will get asked everything from, “Please explain to me how creation redemption works for a swap‑spaced ETF,” which is a very nerdy, inside baseball question, to really basic stuff, like, “How can I figure out the fair value of my ETF?” or “Should I never use market orders when trading?” which is pretty much ETF 101.

There have been surprisingly few questions about smart beta funds. I think the questions we’ve gotten tend to be very skeptical, which isn’t that surprising, of the claims of newer smart beta products.

I think that there’s a lot of interest in things like ESG products, which we could talk about being a flavor of smart beta, if you will, using environmental, social, and governance criteria to make your investments. It’s really just another kind of factor. In general, pretty healthy skepticism.

Sounds like there is plenty to talk about at the upcoming Inside Smart Beta & Active ETFs Summit in New York on 6 and 7 of June, where you will be appearing in a few sessions. What are you looking forward to at that event?

This market never ceases to amaze me. If you look at the list of sponsors and the lists of people who are onstage, there is always a better mousetrap out there. While I tend to be a fairly skeptical consumer of that stuff, it’s never boring hearing how somebody else has figured out a way to skin the cat.

Totally agree, it is going to be fun. Thank you very much, Dave. 

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/CSA Images/Snapstock

About the Author(s)
Paul Kovarsky, CFA

Paul Kovarsky is a director, Institutional Partnerships, at CFA Institute.

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