Passive Solutions Designed By Active Portfolio Managers

#Lifestyle Wealth
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Sponsored by Columbia Threadneedle Investments

An interview with Marc Zeitoun, CFA®
COO of North America Distribution,
Head of Strategic Beta & Private Client Advisory

Where do you see the Strategic Beta ETF industry headed?

In our opinion, strategic beta (also known as “smart beta”) will continue to gain acceptance by a wider range of investors and advisors. This is because strategic beta fills an important pricing gap that exists between low-cost benchmark investing and traditional alpha-seeking, active management.

Strategic beta has been a difficult term for people to understand. Some investors like to describe it in terms of factors whether they be momentum, value or low volatility. We have found that technical and factor descriptions of how strategic beta works are not understandable to many retail investors. Instead, we prefer to simply explain that strategic beta solutions fit on an investment continuum that stretches from pure benchmark passive beta on one end, to alpha-seeking active management on the other. Strategic beta solutions are index-based and are designed with intent. They differ from benchmark passive in that they are constructed as portfolios, deliberately addressing specific investment objectives.  In other words, they're a potentially cost-efficient way of capturing some of our portfolio managers’ and research analysts’ best thinking.

Can you discuss the popularity of ETFs, especially in fixed income?

Popularity with passive fixed income investing has largely been limited to conventional benchmarks like the Barclays Capital U.S. Aggregate Bond Index (the “AGG”) or other widely known benchmarks in specific segments, like high yield, emerging market debt or even national municipal bonds. Despite their widespread use, many investors don’t realize that their construction process (their “rules”) can often lead to counterintuitive, unintended risks. For example, with equity indices, conventional benchmarks tend to employ a market-cap weighting schema, which means they are weighted based on the market value of the companies. More valuable companies therefore have a larger weighting in the index than less valuable companies – this makes some intuitive sense, albeit not very thoughtful.  With Fixed Income, however, when bonds are “cap-weighted” – the outcome is not the same. They're weighted by the size of the debt issue.  This means you are not mostly investing in the most valuable bonds; you're mostly investing in the largest debt.  From an unintended consequence perspective, when you are buying a fixed income benchmark, you are disproportionately buying bonds from some of the most indebted issuers.  This means fixed income benchmarks are not weighted toward opportunity; they're weighted toward indebtedness. That’s what’s counterintuitive. We believe investors should want to invest in bonds with the greatest potential opportunity. That’s where strategic beta comes into play.

Strategic beta brings a thoughtful, disciplined approach to fixed income investing. And while it is index-based, it is designed to potentially address unintended risks and better align with client investment objectives.  We approach index creation differently and say, "Let me screen for liquidity. Let me screen for quality. Let me screen for opportunity." This way, you can develop thoughtful exposure to fixed income even in a passive setting. At Columbia Threadneedle, we are very proud of our strategic beta suite. Our indexed fixed income portfolios were designed by active managers, based on true investment experience in fixed income. We are showcasing that active insights in a passive wrapper work even in fixed income. We've done this on the taxable and tax-free sides.

Where do these strategic beta ETFs fit? It’s easiest to imagine a continuum, extending from left to right. Now, put pure beta on one side and pure alpha on the other side. Consider those two extremes as bookends — all beta, no alpha on one end (reminder, benchmarks have no alpha) and all alpha, no beta on the other. When advisors and investors think about solutions for their portfolios, they are going to pick from somewhere on that continuum. Strategic beta sits neatly in the middle of that continuum because it offers a form of beta that is alpha seeking. It is not entirely alpha because it's not driven by active trading, nor is it reactive to news events or earning reports. Rather, it's trying to deliver exposure within a secular framework.  It effectively encapsulates basic tenets of our portfolio management and research processes and does not expose investors to the randomness of pure beta benchmarks.  Reflecting the half-way point between low-cost beta and best-thinking alpha, strategic beta pricing sits in the middle of the beta/alpha continuum as well. That’s why we believe strategic beta is a convenient way of getting active insights at passive pricing.

Columbia Threadneedle offers a range of products in the fixed income space. What would you want advisors to know about fixed income?

Two things: 1. Fixed income continues to be an important asset class for many investors, and 2. We are great fixed income managers. Unfortunately, many people who invest in traditional fixed income benchmarks are not tapping into that expertise and are therefore limiting their opportunity set. 

If you look at the AGG for example, the benchmark only captures about 40% of the global bond opportunity. It is approximately 72% to 76% U.S. government-issue backed.  In many ways, it doesn't offer exposure to many different sectors of fixed income such as credit. It is effectively a duration play as it largely provides exposure to a single sector – with little yield opportunity.

Our fixed income strategies are diversified. The Columbia Diversified Fixed Income Allocation ETF (DIAL)

seeks to depart from the conventional benchmark.  It was constructed to have a very thoughtful and disciplined allocation across six different sectors. It was designed to be the intersection of quality, liquidity, and yield.  It is a very convenient portfolio.

With such a crowded ETF space, how does Columbia Threadneedle set itself apart from other ETF providers?

First and foremost, culturally, we are a house united – a house united around encapsulating our best thinking and providing it to our clients in different strategies and vehicles. That's very important. It’s our collaborative culture that permits active managers to freely and willingly develop passive solutions that are based on their own expertise. This is something that you don't see very often.

In a recent survey, 72% of financial advisors said they believe asset managers have a responsibility to offer their best investment ideas and incorporate their research insights into all products — including passive ones.1 We agree. But that is hard to do if you buy the S&P 500 Index.  That is why we infuse our best thinking into our ETFs. We encourage investors and advisors to open their ETF prospectus to understand who is managing their money. Whichever passive or active vehicle you are invested in, it is critical to understand who built the rule set to where you, and your clients, money is invested.

At Columbia Threadneedle, our 152 fixed-income investment professionals manage $178.2 billion in global fixed-income assets.2 We tapped into this extensive experience and expertise to create Columbia Diversified Fixed Income Allocation Fund (DIAL), an ETF designed to thrive in uncertain markets. We then did the same thing on the taxable fixed income side with Columbia Multi-Sector Municipal Income ETF (MUST).  We are making our in-house competencies available to our clients in both alpha and strategic beta driven solutions.

On the equity side, with Columbia Research Enhanced Core ETF (RECS) and Columbia Research Enhanced Value ETF (REVS) we did something innovative which we feel appeals to many benchmark investors. Although we do not agree that benchmarks make great investment portfolios, we recognize that some clients are happy with them. They understand some of the unintended risks, and are comfortable with the opportunity limits associated with conventional beta investing.  To address those preferences, and keep true to our belief that research matters, we developed low-cost benchmark-based strategic beta portfolios that track conventional benchmarks but also avail themselves of a research overlay.  We took the Russell 1000 and the Russell 1000 Value indices, overlaid our in-house equity research, and simply removed the companies that we did not have conviction for. In essence, we took out what we believed was the “trash.”  These funds offer active insight at passive prices, since they are priced in-line with conventional benchmarks. 

Again, if you want our best thinking, then you should consider our active-managed solutions first. But with that comes a justified, premium price. If you would like a solution that is more cost efficient, but still reflects a researched point-of-view, then our strategic beta ETFs can be the right vehicles.  We understand that not every investor wishes to access alpha at any price. We just continue to believe that over time, better insights lead to better outcomes.

How are your Strategic Beta ETFs withstanding the current market environment?

We are proud of the performance and have seen continued flows into our products as a result. We encourage any advisors interested to contact us for further information. Our sales team can provide further information and run potential fund comparisons to see where you benchmark. Our website, www.columbiathreadneedleus.com/ETFs can take you to our fund line-up. We also have a thought leadership site, dedicated to producing timely and relevant information.

What are the top three takeaways you'd want advisors to know?

1: Our research reveals that advisors expect their asset managers to leverage their investing experience and knowledge in everything they do, including passive management. We invite advisors to question managers and index sponsors as to who created the investing rules set of the solutions they are using.  The answer is easy for us: It’s our active portfolio managers.

2: We believe strategic beta has become more and more accepted. It’s an efficient way to build client-relevant portfolios at cost-efficient price points.

3: Our ETF website (www.columbiathreadneedleus.com/ETFs) includes a lot of information on how to conduct due diligence on ETFs because we think that it's something that investors and advisors seek. We'd urge people to understand that there's a lot more thoughtfulness that goes into strategic beta ETF products that they should consider – setting strategic beta apart from your conventional benchmarks.

Disclosure:

The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be appropriate for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.

1 Columbia Threadneedle Investments ETFs Survey of 116 financial advisors conducted in August 2019.

2 AUM as of 03/31/20 and personnel data as of 12/31/19. Total investment professionals include additional professionals integral to the investment process including multi asset/alternatives, economists, client portfolio managers, and investment risk professionals.

Carefully consider the fund’s investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the fund’s prospectus, which may be obtained by calling 888.800.4347 or by visiting the funds website: www.columbiathreadneedleus.com/etf to view or download a prospectus. Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. There is no guarantee that the investment objectives & or strategies will be met.

ETF shares are bought and sold at market price (not NAV) and are not individually redeemable. Investors buy and sell shares on a secondary market. Shares may trade at a premium or discount to the NAV. Only market makers or “authorized participants” may trade directly with the Fund(s), typically in blocks of 50,000 shares.

It is not possible to invest directly in an index. The Bloomberg Barclays U.S. Aggregate Bond Index (the “AGG”) is a market-value-weighted index that tracks the daily price, coupon, pay-downs and total return performance of fixed-rate, publicly placed, dollar-denominated and non-convertible investment-grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity.  The S&P 500 or Standard & Poor's 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. The Russell 1000 index comprises approximately 92% of the total market capitalization of all listed stocks in the U.S. equity market and is considered a bellwether index for large cap investing.  The term Russell 1000 Value Index refers to a composite of large and mid-cap companies located in the United States that also exhibit a value probability.

Fixed income securities Involve interest rate, credit, inflation, illiquidity and reinvestment risks. Interest rate risk is the risk that fixed income securities will decline in value because of changes in interest rates. Generally, the value of debt securities falls as interest rates rise. Fixed income securities differ in their sensitivities to changes in interest rates. Fixed income securities with longer effective durations tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter effective durations. Effective duration is determined by a number of factors including coupon rate, whether the coupon is fixed or floating, time to maturity, call or put features, and various repayment features. Below investment-grade securities, or “junk bonds,” are more likely to pose a credit risk, as the issuers of these securities are more likely to have problems making interest and principal payments than issuers of higher-rated securities. Lower-rated securities may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher-grade securities, and prices of these securities may be more sensitive to adverse economic downturns or individual corporate developments. If the issuer of the securities defaults, the ETF may incur additional expenses to seek recovery. Generally, rising interest rates tend to extend the duration of fixed rate mortgage-related securities, making them more sensitive to changes in interest rates. As a result, in a period of rising interest rates, if the ETF holds mortgage-related securities, it may exhibit additional volatility. In addition, adjustable and fixed rate mortgage-related securities are subject to prepayment risk. The fund is passively managed and seeks to track the performance of an index. The fund’s use of a “representative sampling” approach in seeking to track the performance of its index (investing in only some of the components of the index that collectively are believed to have an investment profile similar to that of the index) may not allow the fund to track its index with the same degree of accuracy as would an investment vehicle replicating the entire Index. In addition to the multi-sector bond strategies employed, the fund may invest in other securities, including private placements. The Fund may have portfolio turnover, which may cause an adverse cost impact. There may be additional portfolio turnover risk as active market trading of the fund’s shares may cause more frequent creation or redemption activities that could, in certain circumstances, increase the number of portfolio transactions as well as tracking error to the Index and as high levels of transactions increase brokerage and other transaction costs and may result in increased taxable capital gains. Foreign currency risks involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, from economic or political instability in other nations or increased volatility and lower trading volume. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. Fixed-income securities present credit risk, which includes issuer default risk. The fund is subject to municipal securities risk, which includes the risk that the value of such securities may be affected by state tax, legislative, regulatory, demographic or political conditions/factors, as well as a state’s financial, economic or other conditions/factors. The fund may invest materially in a single issuer and, therefore, be more exposed to the risk of loss than a fund that invests more broadly. Prepayment and extension risk exists because the timing of payments on a loan, bond or other investment may accelerate when interest rates fall or decelerate when interest rates rise which may reduce investment opportunities and potential returns.

Brokerage commissions may apply and would reduce returns. Diversification does not eliminate the risk of experiencing investment losses. The beta of an investment is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. Alpha is a measure of the active return on an investment, the performance of that investment compared with a suitable market index. Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Quality is based on a set of clearly defined fundamental criteria that seeks to identify companies with outstanding quality characteristics. Liquidity is how easily assets can be converted into cash. The yield on a security is the amount of cash that returns to the owners of the security, in the form of interest or dividends received from it.

Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies. The funds are distributed by ALPS Distributors, Inc., and managed by Columbia Management Investment Advisers, LLC. ALPS is not affiliated with Columbia Management Investment Advisers, LLC.    

3126560 (6/20) / CET001093 Exp. 3/31/2021

https://www.wealthmanagement.com/etfs/passive-solutions-designed-active-portfolio-managers

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