October 7, 2021

    ETF Insider

    Welcome to this week’s ETF Insider. Smart beta’s shine has faded a bit, and it’s thematic ETFs’ turn to get the spotlight. We also look at why regulators may want to make new rules affecting how advisors recommend leveraged ETFs to clients. Also this week, Vanguard officially jumps into direct indexing.

    Tell us what you think, and what you’d like to read more of: editorial@financialadvisoriq.com

    Jackie Noblett, producer of ETF Insider at Financial Advisor IQ.

    Thematic ETFs Have Stolen Some of Smart Beta’s Spotlight, But Don’t Count Factors Out

    Morningstar’s ETF guru, Ben Johnson, quipped two weeks ago that talk about strategic beta – also known as smart beta – was conspicuously missing from the research firm’s annual conference agenda, along with business cards, ties and dress shoes.

    Indeed, the buzz around factor-tilting strategies appears to have faded while mega-trend-following funds focused on ideas like electric vehicles and biomedical innovations have captured the lion’s share of the attention from ETF providers and advisors alike.

    Last quarter, 27 thematic ETFs debuted, according to State Street Global Advisors. That is more than triple the number launched, on average, during any quarter in the past three years, the Boston-based firm’s research indicates. Meanwhile, year-to-date through Monday, just 13 ETFs that meet Morningstar’s definition of strategic beta have launched. That compares to 21 for all of 2020 and 65 in all of 2017.

    State Street's Matthew Bartolini on how past years' thematic and smart beta ETF product launches are now fueling investor adoption.

    Like so-called smart beta, thematic funds go after clients’ overarching desire to generate outperformance relative to cap-weighted benchmarks in a more systematic manner than subjecting their portfolios to the whims of a single active manager, analysts and product providers say. Indeed, both thematic and smart beta strategies can fit in the 10% to 20% of portfolios that advisors generally allocate to “explore” strategies beyond core holdings, said Jeremy Schwartz, global head of research at WisdomTree.

    But thematic and smart beta ETFs vary significantly in their approach to delivering outperformance, their use cases, and, importantly, in how end clients understand them, industry leaders note.

    Thematic strategies are in many ways “diametrically opposed” to smart beta in that they focus on companies that will benefit from major changes in the world, inherently tilting portfolios toward high-growth, high-beta and smaller stocks, said Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors.

    Traditional smart-beta strategies, by comparison, tilt toward value, quality and lower volatility stocks — factors that historically have outperformed, he added.

    The problem for smart beta is that they’re wonky, and often have been targeting the wrong factors. “What’s worked for the past 10 years has been growth,” WisdomTree’s Schwartz said. Thematic strategies, meanwhile, appeal to a desire to “find unique stories to fill out the growth style box,” he added.

    Explaining to clients the investment thesis behind electric vehicles or cloud computing or the work-from-home movement may be easier than breaking down the historical performance of Fama-French factors.

    But is smart beta dead as an investing concept? Not at all, product providers say.

    WisdomTree recently rolled out an ETF combining growth and momentum factors, all while packaging its own and third-party thematic ETFs into models that can complement its other core smart-beta strategies. Columbia Threadneedle, meanwhile, has invested heavily in smart-beta fixed-income ETFs, including last month’s launch of its Short-Duration Bond ETF.

    These managers even argue that thematic and smart beta can live together in the same portfolio, working to provide outperformance at different times. So advisors don’t have choose between between their old friend and the new kid on the block.

    SEC Takes Second Crack at Tightening Access to Leveraged ETFs

    FAs who thought they dodged a bullet when the Securities and Exchange Commission cut provisions that would require advisors to vet investors before letting them buy leveraged and inverse ETFs may need to think again.

    While the terms were pulled from the agency’s 2020 derivatives rule, they’re back on the docket as part of renewed scrutiny of so-called complex exchange-traded products.

    On Monday, SEC Chair Gary Gensler ordered the commission’s staff to draw up a list of potential new rules that address the risks of investing in complex ETPs. Gensler announcement specifically cited leveraged and inverse ETFs, which typically seek to give investors exposure to two- or three-times the daily returns of an index or its opposite, as an example of a product that can harm investors who do not know how to use them properly.

    Indeed, the SEC and Finra repeatedly have hit broker-dealers and individual advisors with sanctions for improper recommendations or oversight of the products. In February 2020, Wells Fargo paid $35 million to settle with the SEC over poor supervision of inverse ETFs. And just two months ago, Finra ordered Sanctuary Securities to pay a $530,000 fine over failing to supervise 30 brokers who solicited sales of leveraged and inverse products.

    Although the SEC sought to address some of these usage concerns through the derivatives rule, it ultimately pulled the added vetting burdens on advisors, online brokerages and other intermediaries amid an outcry – more than 5,000 comment letters -- that the red tape would cause investors to lose access to the products. Instead, the rule reopened the pathway for firms to launch new leveraged and inverse products. Then-Chair Jay Clayon paired the passage of the revised rule with a call for a broader examination of complex ETPs.

    It’s too early to tell whether advisors should expect to see a re-hash of the increased due diligence requirements or additional sales practice regulations.

    Many broker-dealer home offices already restrict access to the souped-up products. A 2019 survey of 118 broker-dealers sponsored by the North American Securities Administrators Association found that just 73% allowed leveraged or inverse ETFs to be held in retail customer accounts. Within that group, only 52% of shops allowed registered representatives to recommend them.

    “We are overdue for a comprehensive and consistent approach to the review of complex exchange-traded products and the sales practices issues that they present,” said Commissioners Allison Herren Lee and Caroline Crenshaw in a joint statement issued Monday. The pair called providing a framework for how advisors should vet suitability of such products “most critical” to any new rule.