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Should You Buy Smart Beta ETFs or Get an Active Manager Should You Buy Smart Beta ETFs or Get an Active Manager
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Should You Buy Smart Beta ETFs or Get an Active Manager?

Ron Joelson •  August 7, 2017 | Your Finances, Ask the Expert

Each month, we book time with some of our company’s top financial brain power to answer questions about investing and your finances. This month we’re talking about smart beta ETFs and what they mean for your investments.

Ron Joelson

Ron Joelson is Northwestern Mutual's chief investment officer and oversees the company's general account, valued at more than $200 billion.

Mark McLennon

Mark McLennon is vice president of Investment Products and Services (IPS) Business Development. He oversees trust services and the fee-based financial planning program as well as departmental growth initiatives.

Brent Schutte

Brent Schutte is chief investment strategist of Northwestern Mutual Wealth Management Company. He oversees the investment philosophy for individual retail investors and the investment strategy for more than $100 billion in assets under management as of December 2016.

Do you have a question for our financial experts? Email it to us at: AskTheExpert@northwesternmutual.com

The following is an excerpt from our Ask the Financial Expert podcast (listen to the entire podcast below):

Mark: We’ve talked about active and passive investing in the past, but there’s another angle to that discussion. Today we want to talk about so-called “smart beta” funds. Ron, what’s happening here?

Ron: People have been rapidly shifting their money from active managers—real people who pick stocks—to passive management, which is basically just a fund that is designed to mirror a particular index like the S&P 500. Some of these fund vehicles are purchased in “exchange-traded funds,” or ETFs. As that’s happening, a lot of asset managers are trying to get back some of the money that’s moving away from active management. So they’ve created a number of what we call smart beta ETFs and smart beta funds.

Smart betas are designed to attract investors in more traditional index funds, like those that mirror the S&P 500. For instance, they might put more focus on small companies rather than large ones in the index. Or, smart beta funds can be based on other factors, such as low valuation, return on equity, growth or price-to-earnings ratio. The funds can set up predefined rules and be very transparent about them, which investors like.

The thought is that active managers who are outperforming indexes like the S&P 500 are focusing on some of these same factors. Smart beta supporters believe that you don’t really need to pay for that because the design of the smart beta fund can re-create it at a lower cost.

That’s the theory, but I have a couple concerns. First, these were really designed in an attempt to capture money that’s already flowing away from active managers. Second, these were created by testing what factors led to growth in the past. Back testing is great, except that it’s always going to show you a positive return because you’re looking backward. It isn’t necessarily indicative of real performance going forward. For example, a lot of the factors that would have predicted growth between 2003 to 2007 stopped leading to growth after 2007. If you’re going to back test, you give an investor a potentially very false sense that this thing works.

Brent: The popularity of these things alone almost dooms them to some period of underperformance. Anomalies always exist in the market. But anomalies exist because people don’t know they exist. People learn about these anomalies, which then go away because everybody piles into them. If you tell everybody where your favorite fishing hole is and they start fishing it, it won’t be a good fishing hole anymore.

I think one positive thing is that it does make active managers up their game. But I believe there will  always be room for the active manager and stock picking. The difference is that active managers aren’t just going to be able to use these kinds of factors and charge a percent for it. They’re going to have to prove they have a “secret sauce” and can find value in order to charge for it.

I think it’s good for the individual investor that these funds exist. I would just hazard or caution a bit against piling into them right now. It doesn’t mean they won’t work in the future; it just means that their popularity right now means that they’re fully exploited.

Ron: And you can use these smart beta funds to determine whether an asset manager—an active manager—is really doing his or her job. So, for example, if an active manager’s performance is the same as what you could get out of a particular fund, then you can ask what that manager really added.

Brent: And we do. We look back historically and make sure that if we’re paying for an active manager, we want to pay for something that is skillful and that’s not replicated easily. There are still active managers out there right now who have proven that they do have something that is different and that it has led to long-term outperformance.

Mark: So if you’re utilizing both active and passive, it’s important to make sure the active managers are really adding value; and in the passive, make sure it is tracking what it’s supposed to be tracking and presumably at a lower cost, right?

Brent: There’s room for each in your portfolio. But I think it’s worth looking at the popularity of ETFs. That’s led to fewer people using active managers and, as a result, fewer active managers. When there’s less of something, that means that there’s a bigger opportunity.

When you have thousands of active managers looking at an individual stock’s balance sheet and income statement, there isn’t much more incremental that we can find because there are a lot of detectives.

But if there are fewer active managers, there are now more opportunities to find something that someone else hasn’t found. The popularity of ETFs is only making that opportunity bigger because people are buying stocks without regard for any sort of value. They just buy them in one fell swoop through a fund.

Hear more from Ron, Brent and Mark in the “Ask the Financial Expert” podcast:

Do you have a question for our financial experts? Email it to us at: AskTheExpert@northwesternmutual.com

The opinions expressed are those of individual investment professionals as of the date stated on this article and are subject to change. This material does not constitute investment advice, is not intended as an endorsement of any specific investment or security and is not a prediction of what will happen in the markets.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise; and conversely, when interest rates rise, bond prices typically fall. This also holds true for bond mutual funds. When interest rates are at low levels, there is risk that a sustained rise in interest rates may cause losses to the price of bonds or market value of bond funds that you own. At maturity, however, the issuer of the bond is obligated to return the principal to the investor. The longer the maturity of a bond or of bonds held in a bond fund, the greater the degree of a price or market value change resulting from a change in interest rates (also known as duration risk). Bond funds continuously replace the bonds they hold as they mature and thus do not usually have maturity dates and are not obligated to return the investor’s principal. Additionally, high-yield bonds and bond funds that invest in high-yield bonds present greater credit risk than investment-grade bonds. Bond and bond fund investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk and inflation risk before investing in a particular bond or bond fund.

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