Strong growth in enhanced beta

Enhanced beta refers to those passive products that track non-traditional indices – in other words those not based on market capitalisation. They give exposure to other market factors such as dividends, earnings, low volatility or growth and value factors.

Morningstar’s “Global Guide to Strategic-Beta Exchange-Traded Products” for 2015 shows that assets under management in global enhanced beta products grew by 25.2% in the 12 months to June. There was $497.3 billion invested in these products at 30 June this year, up from $397.3 billion in 2014.

This level of growth was also reflected in the number of enhanced beta ETPs available worldwide. From 678 last year, the number grew to 844 in 2015.

Morningstar noted that while the market share of these products increased in every region they looked at, it was most pronounced in larger, developed markets.

“For example, strategic-beta ETPs accounted for 21.2% of U.S. ETP assets but just 2.9% of ETP assets in the Asia-Pacific region,” the report said.

Despite the different levels of uptake, there are however a number of common themes across the globe. The first is that dividend-screened or weighted strategies were most popular in all but on region examined.

“This should come as little surprise when considered in the context of the prevailing interest-rate environment,” Morningstar said. “Investors around the globe have piled into dividend-paying equities, shunning the low (or negative) real yields offered by issues from developed-markets sovereigns.”

The study also found that in all regions, enhanced beta charged expense ratios that were more competitive than those charged by active managers. However, in some cases they charged fees much higher than traditional passive products.

Morningstar however expects that the rapid growth in the market will begin to have an impact here.

“Growth and maturation will ultimately lead to a culling of the herd, which has already begun in some geographies, albeit to a limited extent,” the report states. “An increasingly crowded and competitive landscape will also put pressure on fees. We have already seen instances of aggressive fee reductions for strategic-beta ETPs.”

A third common and significant trend is that the benchmarks being tracked by these products are becoming increasingly complex. This is part of a broader trend in passive strategies where exposures are becoming more specific.

While this does give investors greater choice and flexibility, it also means that they have to be more aware of what they are buying.

“As these strategies become increasingly nuanced, looking to infuse elements of an active manager’s thinking into an index, investors’ collective due-diligence burden will continue to increase commensurately,” Morningstar notes.

This has been a concern in South Africa where many investors have been attracted to enhanced beta based on the past performance of the underlying index. However, they haven’t examined how that performance was generated.

When market cycles turn and the factors influencing performance change, investors have often been disappointed. This has underlined the need to appreciate what you are buying as an investor, and what factors will influence returns.

The report noted that South Africa has the largest enhanced beta offering amongst emerging markets. Morningstar anticipates that it will follow the lead of the US and other developed regions where these strategies are becoming more important in portfolio construction.

“Given the nature of these [emerging] markets, information about these products is often lacking, and local investors are generally unfamiliar with ETPs, and more unfamiliar yet with the concept of strategic beta,” the study says. “As these markets continue to develop, both from a fundamental and asset management/investment perspective, we expect them to ultimately look to mimic the developments witnessed among more-mature markets. Specifically, we would expect to see a gradual adoption of the ETP vehicle and more-complex strategic-beta-type exposures.”