The current market downturn is prompting investors to rethink their asset allocation strategies, paving the way for an expanded role for smart beta exchange-traded funds (ETFs) and thematic ETFs in their portfolios.

That’s because an investment portfolio with substantial allocations in smart-beta ETFs and thematic ETFs may be better positioned to withstand the downward trend in financial markets brought about by inflation, rising interest rates, global economic uncertainty, the Russian-Ukraine war, the persistent pandemic, and a potential economic recession.

“The more recent correction is putting a question mark to people as you can observe from the market that a lot of the thematic strategies are actually very growth-focused such that they have become victims of the momentum crashes, or any of the growth or valuation corrections that we have seen in recent months,” says an asset manager who specializes in smart-beta strategies.

While regular thematic ETFs, which do not to have fundamental screens, may offer diversification which is generally beneficial to a portfolio, they are also impacted by market volatility because of their growth focus.

Smart-beta ETFs which use fundamental screens (a rules-based, systematic approach to choosing stocks from a particular index), on the other hand, generally benefit from a more consistent growth and performance, thus providing the portfolio with more resilience during market downturns. On the flipside, a smart-beta strategy may give up some upside in a bull market but provides some protection during a market correction.

Gaining popularity

The recent growth in the popularity of smart-beta ETFs and thematic ETFs is an indication that investors and asset managers are actively trying to find ways to deploy these types of strategies within their conventional asset allocation models.

“I think that is a good development because it also shows that people are seeing the benefit of smart-beta ETFs in filling the gaps of the conventional asset allocation model or the broad-based ETFs. These are the gaps that they have right now,” says the asset manager.

A smart-beta strategy usually did not have a place in the traditional asset allocation model because it meant that investors would have to go off benchmark. But this has been changing in recent years based on the growth of smart-beta ETFs.

Smart-beta products have become more popular in Greater China than in Europe or the United States, with 69% of investors having 11% or more of their assets under management (AUM) in smart-beta strategies. This compares with 50% in Europe and 68% in the US, according to the latest data from Statista Research Department.

In Europe, smart beta’s share of the total exchange-traded products (ETP) market increased from less than 1% in 2005 to 6% in 2020. By the end of 2020, the number of ETPs reached 160 and their total AUM amounted to €63 billion (US$67.35 billion), according to a study by Deloitte.

Outperforming benchmark

The largest smart-beta ETF, the Vanguard Value ETF VTV, with US$96.91 billion in AUM as of May 23 2022, for example, has consistently outperformed its benchmark since its inception on January 26 2004. In the last year, the best-performing smart-beta ETF was the ProShares Ultra Bloomberg BOIL at 399.88% and US$225 million in AUM.

At present, there are two types of asset allocation models that investors and asset managers are using as they rethink their strategies through the current market downturn.

The first model, which is more traditional, deploys thematic ETFs, both conventional thematic ETFs and smart-beta ETFs, to the bucket of actively managed assets that is designed to generate alpha versus the bucket of passively managed assets that purely tracks the market indices.

The second model deploys thematic ETFs and smart-beta ETFs to the bucket of more aggressively managed assets where they expressed their views or convictions with regard to specific investment themes such renewable energy, climate change, environment or ecology, or socially oriented themes.

“At present, more institutional investors tend to use the traditional asset allocation models and that belongs to the first model using smart-beta ETFs or the thematic ETFs for alpha,” the asset manager says. “But that is expanding more recently because of the rate hike expectation. A lot of people are rethinking their asset allocation model so that provides a very good window to re-engage clients to see the appropriate way going forward.”