Smart Beta basics

by , 4th August 2017

The idea behind ‘Smart Beta’ is that you can create an ETF that can potentially beat the market whilst avoiding the need for expensive fund managers to pick the stocks.

Traditional passive ETFs track well-known indices such as the FTSE 100 or the S&P 500. But Smart Beta ETFs focus on particular themes or ‘factors’ such as value, momentum, income or smallcaps. Indices are then created that focus on these factors and then a Smart Beta ETF will track one of these indices.

Peter Sleep, Senior Investment Manager at 7IM, says at its simplest Smart Beta is ‘an alternative way of weighting an index.’

Smart Beta investing is also known as ‘Factor investing’, ‘Alternative Beta investing’ or ‘Style investing.’

One popular example of a Smart Beta fund is the popular Powershares S&P 500 Low Volatility Portfolio in the US which tracks the S&P 500 Low Volatility Index. This index comprises the 100 least volatile stocks in the S&P 500.

What is Beta?

If you’re wondering what Beta is, it’s a measure of the volatility of a security or portfolio when compared to the market as a whole. A beta of 1 indicates that a security’s price moves in line with the market. A beta of less than 1 means that the security should be less volatile than the market whereas a score of more than 1 indicates that volatility should be higher than the market.

There’s a fair bit of academic research to support the idea that focusing on investment factors can deliver market-beating returns. For example, Frazzini, Kabiller & Pedersen analysed Warren Buffett’s investment  success and argued that his performance can be ascribed to using three key factors alongside cheap borrowing. The factors were Quality (buying stocks with significant financial strength), Volatility (going for low volatility stocks) and Value (picking stocks where the price is below or close to recognised measures of value.)

Research by Elroy Dimson of the Cambridge Judge Business School shows that £1 invested in a FTSE Growth portfolio in 1955 would have grown to £419 by the end of 2016, a return of 10.3% a year. £1 in FTSE Value portfolio would have grown to £9173, an annualised return of 16.0%.

Advantages of Smart Beta

Before Smart ETFs were created, if you wanted to follow, say, a value strategy, you had two options. You could either pick value stocks yourself and build your own portfolio or you could invest in an active fund with a value-oriented fund manager. The problem with picking the stocks yourself is that you may discover that you’re not a market-beating investor. And when it comes to traditional value funds, there are several minus points.

Firstly, there is the issue of cost. You’re always going to pay more for an active manager. Smart Beta funds are a bit more expensive than traditional passive funds, but only a bit more expensive, sometimes as little as five or ten basis points.

Secondly, the fund manager may say he’s a firm value investor, but he can easily wander into other areas if he loses focus. If you take the Smart Beta approach, that should never happen. A value Smart Beta ETF should be tracking a value index with clear, transparent rules. As long as the index sticks to its remit, then the ETF will do so too.

And thirdly, there’s the risk that a star manager might defect to a different fund management company. Then the private investor has to decide whether to move their money to the manager’s new fund, which will carry a cost, or stick around and see whether the replacement manager can deliver decent performance.

The beauty of Smart beta is that if you decide your objective is to go for income, then there are plenty of Smart Beta ETFs that can give you that simply and cheaply. And that applies to other factors too.

Smart Beta also has no ‘size bias.’ If you buy a conventional ETF tracking the FTSE 100, the largest chunk of your money will go to the biggest stocks in the Footsie such as HSBC, BP and GlaxoSmithKline. That’s because most traditional indies weight their constituents purely on the basis of market cap. However, there’s no guarantee that the largest stocks in the FTSE 100 will be the best performing Footise stocks over the next ten years.

Smart Beta gets round this problem by applying other factors as well as (or instead of) market cap.

Possible downsides

There are no guarantees that a particular factor will continue to deliver outperformance, especially if that factor has been fashionable recently and investors have bid up prices for this factor too high.

There’s also a danger of creating an index that is designed carefully to prosper in the past and through particular events such as the financial crisis. Peter Sleep, Senior Investment Manager at 7IM, argues that some Smart Beta indices include complicated risk controls to ensure that the strategy would have performed relatively well in the financial crisis in 2008 and the eurozone crisis in 2012. Overcomplicating the strategy may crimp future performance especially since history rarely repeats itself exactly – future crises will have their own individual characterstics.

Sleep suggests that investors should choose an ETF where the ETF provider doesn’t also operate the index – that should reduce the chance of backtesting problems. He also thinks that investors should diversify across more than one smart beta strategy.

It probably also makes sense to use smart beta as part of a wider portfolio which may include some traditional passive funds.

Adam Laird, Head of ETF Strategy, Northern Europe, at Lyxor, thinks it’s a mistake to go for too complicated a set of factors.

Not just for equities

Smart Beta isn’t just used for stock market investing, smart beta is becoming increasingly popular for bond investors too. In fact, smart beta is arguably a more attractive option for bond investors than for equity investors. That’s because a market-cap weighted bond index will be weighted towards the most indebted companies or countries. So passive investors end up lending more to the most indebted borrowers.

Of course, a Smart Beta strategy could be weighted to the least indebted borrowers or a wide range of factors.