Be smart about smart beta

Research shows that it may pay you to include in your investment portfolio passive funds that tap into shares with certain characteristics, writes

There is evidence that tilting portfolios towards certain factors at play in South African financial markets can harness good returns at low costs, but you need to be smart about how you choose a so-called “smart beta” investment strategy.

This is the view of Shaun Levitan, the chief operating officer and co-founder of investment management company Colourfield, who presented the company’s research into what is known as factor-based investing to the recent annual conference of the Actuarial Society of South Africa.

Factor-based investing is often referred to as smart beta investing. “Smart beta” is used broadly to describe any investment that is neither actively managed nor passively tracks an index made up of shares according to their market capitalisation, such as the FTSE/JSE All Share Index (Alsi). (Market capitalisation is the share price multiplied by the number of shares in issue.)

Levitan says about 95 percent of South African investments are actively managed, but more actively managed funds underperform indices (weighted according to the market weighting of shares) than outperform them.

The recent Standard & Poor’s True active managers have nothing to fear from the slowly rising number of passive investments available to you, the chief investment officer of one of South Africa’s larger, very successful fund managers says.

Karl Leinberger, from Coronation Fund Managers, says active and passive investing are complementary, and financial markets function best when there is a broad universe of investors with different strategies and time horizons.

In an article in Coronation’s latest Corospondent magazine, he says the growth in passive investing increases liquidity in the market and therefore the investment opportunities for the genuinely active manager.

However, passive investing makes markets less efficient, because it is biased towards buying high and selling low. It systematically gives higher weights to overvalued stocks and lower weights to undervalued stocks, he says.

Leinberger says that, once a quarter, passive investments are rebalanced to the weightings in the index that they are tracking. These Indices versus Active Funds scorecard shows that more than three-quarters of actively managed South African equity funds underperformed certain benchmark indices over one, three and five years to the end of June this year.

If you fear choosing an active fund manager who is unable to outperform a market-capitalisation index after fees, factor-based investing in smart beta passive funds is an alternative worth considering, Levitan says.

Research over long periods has shown that you will be better compensated for taking the risk of being more exposed to shares with certain characteristics than being invested in a market-weighted index such as the Alsi.

The characteristics that have been identified in research conducted around the world include the size of a company (in other words, large-cap or small-cap shares), value and profitability.

Colourfield has researched the factors that deliver returns in South African financial markets over the past 20 years. Levitan says this research shows that:

• A portfolio that is tilted to small-cap shares has outperformed are his favourite days in the office, he says, because they provide an opportunity to buy cheap stocks and to sell expensive stocks to the passive investment managers. He says passive investments: • Increase the choice of investments for you, which is a good thing;

• Promise low fees, which puts pressure on active managers who charge high fees that are not justified by the value they have added;

• Threaten active managers who have not out-performed or who do not manage truly active portfolios (that is, they construct portfolios that hug benchmarks); and

• Make sense for some investors who have not done the due diligence or taken the advice needed to select skilled active managers, or who do not have the time horizon needed to prosper in financial markets.

Leinberger says notwithstanding the positives, many investors are seduced by the sales pitch without fully understanding some of the “deep flaws” in passive investments.

He says these are: the market by 0.9 percentage points a year;

• Tilting a portfolio towards shares with value characteristics rather than growth characteristics has returned three percentage points a year more; and

• Being exposed to shares of companies with high profitability has delivered one percentage point a year more.

Levitan says low volatility is often identified as a factor that should deliver good returns and is being offered by some smart beta funds in South Africa.

However, he says, international market data shows that, from 1970 to 2015, shares exhibiting low volatility also had a value bias.

Similarly, funds that track the Research Affiliates Fundamental Index (Rafi) have had a very high value bias over time. This is because the Rafi weights shares according to a company’s book value, sales, cash flows and dividends, Levitan says.

However, the Rafi ignores share price in its construction, which is

counter-intuitive, as the return achieved is dependent on the price paid, he says.

Levitan cautions against an investment strategy using momentum as a factor, because the “premium” you expect to get from momentum shares does not last long. This is because the market allocates higher and higher prices to a momentum share and a fund manager needs to buy it at the lower price and sell at a higher price to earn a good return. You need to invest and then sell quickly to earn this premium, Levitan says. This can create a high turnover of shares, which results in high trading costs, he says.

CHOOSE CAREFULLY

Levitan says it is possible to use factor investing to create portfolios with better certainty of returns and lower volatility than those offered by active fund managers, but you or your adviser need to take care when you choose a factor-based or smart beta investment that it is well configured.

He says you or your adviser also need to pay attention to how the factors are integrated, taking into account any inter-relationships between them. It is no good putting together, for example, three different smart beta funds only to find you have created the same effect as owning the market by tracking a marketcapitalisation index.

Finally, Levitan says, the investment provider needs to take into account the trading costs.

A factor tilt, such as one towards small-cap shares, may appear amazing on paper, but when a fund manager comes to buying and selling these stocks, they may be difficult to trade because they are illiquid – in other words, there are so few of them in circulation. This is particularly true of the 50 smallest stocks on the JSE.

In order to buy these shares in the quantity it needs, a manager may destroy, rather than create, value, Levitan says.

Investments that track market-capitalisation indices have to trade shares quickly, and active fund managers also have to act fairly quickly on their research. This can increase trading costs. But these costs can be contained in a portfolio that takes more time to invest in shares products in particular often involve far-reaching active decisions. These decisions are not being supported by a team that has the skills, the experience, the extensive research capabilities and the deep understanding of the underlying securities, he says.

• Passive investment fees are not low for individual investors. Leinberger says large pension funds probably secure fees of less than 0.2 percent a year, but retail investment fees are much higher. The total investment charge (TIC) for the five largest equity tracker unit trusts is 0.78 percent a year, on average.

The equivalent number for the largest equity exchange traded funds (ETFs) in the market using a like-forlike comparison and assuming the cheapest brokerage costs, is lower, but still high, at 0.46 percent a year, he says.

The TICs for smart beta products are significantly higher than the pure equity trackers; in many cases they are close to the TICs of genuinely active funds.

• Some passive investments with the right characteristics, Levitan says.

Levitan says trading costs are also an issue in funds that equally weighted shares, such as those that offer equally-weighted exposure of 2.5 percent to each of the shares in the FTSE/JSE Top 40 Index.

These strategies appear to work because essentially they tilt the portfolio away from the very large shares by down-weighting them. But Levitan says that keeping the portfolio allocations at 2.5 percent per share requires a lot of rebalancing, and this makes the trading costs high.

And you shouldn’t expect a smart beta investment that tracks shares with a certain characteristic to deliver good returns every year – you need to be invested for a meaningful period – at least three years, he says.

At times, a factor may not deliver for a very long time – beginning in 1981, the small-cap sector in the US failed to deliver good returns for seven years.

Factor-based investing means that, in order for an active fund manager to earn what is known as alpha, the manager needs not only to outperform an index, but an index adjusted for the tilts that are represented in that manager’s style.

Levitan says renowned US economists Eugene Fama and Kevin French found that less than three percent of active managers in the US deliver better than factoradjusted indices. underperform their benchmarks by a lot more than their fees, an analysis of historical returns of retail passive investments shows, according to Leinberger. He says he expects this underperformance will become more pronounced as more money is invested in passive investments and they struggle to do the same trades when they rebalance.

• Passive bond funds are “alarmingly flawed”, Leinberger says. As a bond issuer becomes more indebted, it issues more bonds, which, in turn, take up more weight in a market-capitalisation index such as the Citigroup World Government Bond Index (WGBI) for global bonds and the JSE All Bond Index for SA bonds. This is a very perverse outcome, he says. Investors in passive bond funds unwittingly end up in products with a systemic bias to more indebted (riskier) entities.

Leinberger says the active manager that cuts out all the noise and delivers compelling results for clients over long periods (and charges a fair fee for that service) will prosper regardless.