2016 was a breakout year for smart beta. We saw unprecedented inflows of over $55 billion into smart beta strategies globally, which is an impressive 83% increase above that of 2015. There are many more new smart beta products today as well, with over 120 products launched over the course of the year. (Source: BlackRock Business Intelligence, as of 12/31/2016.)
Not surprisingly, investors’ familiarity and usage of smart beta has evolved along with its popularity. This expansion has motivated investors to consider new approaches to incorporate smart beta within their portfolio.
Where will these trends lead us in 2017? Here are my four predictions (and notable developments) that could shape the smart beta and factor investing category.
1. The revival of risk-seeking factors
The rise of smart beta over the past several years has largely coincided with a low growth, defensive market environment. Minimum volatility strategies flourished, with many investors attracted to the potential for downside protection in times of crisis.
Things started to change last summer, however. With growing evidence of a firming global economy and a pickup in corporate earnings taking hold, recessionary fears gave way to a decidedly pro-growth, reflationary theme in markets. Investors have in turn become less defensive and more risk-seeking, favoring securities that provide greater potential for capital appreciation. Value strategies, the most beaten down in past years, returned to favor, as they have tended to do well when market trends reverse (source: Ang, Andrew. Asset Management: A Systematic Approach to Factor Investing. Oxford University Press. 2014.)
We see a strong year ahead for value strategies based on the current reflationary environment as well as attractive valuations and positive price trend. While individual factors are inherently cyclical and reversals of fortune unsurprising, we still see minimum volatility play a lead role in core equity allocations. The potential for market-like returns with less risk is appealing regardless of market regime.
2. Multi-factor strategies take center stage
The performance behavior of individual factors is by nature fickle; a fact made abundantly clear by the tale of two markets in 2016. Depending on what’s going on in the market, one factor may zig while the other zags. The best way to mitigate this cyclicality is to diversify across different factors. A multi-factor strategy, which combines factors with low correlation to each other, has the potential to perform well under a variety of market conditions. Indeed, I like to say that diversification is the first rule of investing, and it’s no different with factor investing. As investors look for higher returns, multi-factor strategies are bound to become a popular avenue for potentially consistent and cost effective incremental returns. But don’t forget: Not all multi-factor offerings are made alike, so careful consideration should be paid to a strategy’s intended outcome and makeup as performance may vary.
3. Fixed income, finally
Although equity smart beta strategies have rapidly gained acceptance in recent years, the fixed income smart beta category remains in its infancy. Savvy readers will note that my 2015 predictions suggested fixed income strategies were poised to grow. While I’d like to claim I’m just ahead of my time, in reflection it’s not surprising that fixed income smart beta strategies have been slower to gain traction. Fixed income is more challenging for a variety of reasons: The bond market trades over the counter so it is significantly more opaque and less liquid, and many issuers simply do not trade. What’s more, fixed income has until very recently remained largely the domain of active mutual funds.
However, as fixed income ETFs are increasingly recognized as a mechanism for improved liquidity and market access, the adoption and interest have also grown significantly over the last year. With that, investors are naturally asking—just as they did with equities—can smart beta approaches help to reduce risk or improve returns in fixed income? Indeed many of the factors you’ve become familiar with in equities are also in bond markets. For example, value and quality can be captured in fixed income. Put simply, inexpensive bonds tend to outperform more expensive bonds, and identifying strong balance sheets can help avoid defaults (source: Ang, Andrew. Asset Management: A Systematic Approach to Factor Investing. Oxford University Press. 2014.) Keep in mind that the fixed income market is full of nuances and requires expertise to navigate, but I think experienced providers can uncover ample opportunities in fixed income smart beta.
4. The portfolio trinity – active, passive and smart beta
The question I’ve been most often asked is where smart beta fits in the portfolio: Should smart beta be a replacement for active or passive strategies? The answer isn’t either-or, in some instances it can be complementary to both. Smart beta has challenged that long-established, binary thinking. More and more I see (and not just in my own presentations!) a trinity of active, passive and smart beta and replacing the traditional approach. Today’s investors are not only managing their risk and fee budgets and trying to find the right proportions, but they are also tasked with finding return amid a less rosy market backdrop. The combination of active, passive and smart beta can help investors to really diversify and take advantage of the fullest opportunity set to meet their investment challenges.
2017 is sure to be a year of many changes, and markets will undoubtedly surprise us in ways we’ve yet to imagine. While change is constant, some things never go out of fashion: Time-tested ideas, robust research and skilled implementation will always serve investors well.