Smart beta questions
A growing number of fund managers are looking at alternative strategies to boost returns
Greater transparency allows investors to make more informed decisions ... and this gives ETFs an advantage
Q What is smart beta?
Smart beta is all about index construction, which refers to which stocks (or other assets) make up an exchange traded fund (ETF) and their relative size within that index. Where traditional market-capitalisation-weighted ETFs (such as the Vanguard Australian Share Index) consider that market size incorporates “all factors”, smart beta ETFs put more focus on some factors over others. Some common smart beta factors include growth versus value, small cap versus large cap or fundamental factors like dividends. CHRIS BRYCKI
Q What are the risks?
All smart beta ETFs are taking bets on certain market factors being more important than others. High-dividend and fundamental smart beta ETFs have a bias towards value stocks. Equal-weight ETFs have a bias towards small companies. The risk of smart beta ETFs is that the factors they’ve selected don’t perform. Smart beta strategies are often marketed as being able to “beat the market”. However, the truth is often a lot more murky. Many have only outperformed from backtesting over a select historical time period and perform poorly after they launch. Others, like equal-weight ETFs, only outperform because they are taking more risk. Investors should be careful of smart beta ETFs that charge significantly more in fees than market-cap-weighted ETFs as that’s likely to harm their returns. Our [Stockspot] 2017 ETF report shows that most smart beta ETFs underperform the broad market ETFs after fees, which is why we don’t typically recommend them to clients. CHRIS BRYCKI
Q Smart beta providers talk a lot about transparency. Why is that important?
There are two key ways strategic beta ETFs provide transparency, similar to their market cap peers. The first is that, given the exchange traded structure, investors have access to the full holdings of strategic beta ETFs. The second is that investors have access to the price of the ETF, or the net asset value (NAV) or indicative net asset value (iNAV), throughout the day. This is unlike traditional unlisted funds that are only priced at the end of the day. Greater transparency allows investors to make more informed decisions, and in an increasingly regulated and competitive environment the industry continues to face pressure to improve transparency. This gives ETFs an advantage over active managers. ANSHULA VENKATARAMAN
Q How would smart beta fit into a portfolio with other investments?
The smart beta funds in Australia are designed to capture the performance of certain factors. The type of factor will determine the role it can play in a portfolio and the funds it can be blended with. Australian or global smart beta equity funds generally sit within the growth component of a balanced portfolio and can be used to blend with other core (market-cap-weighted) exposures, such as the S&P/ASX 200 Index or S&P 500 Index as part of a core-satellite approach.
A challenge with Australian smart beta strategies is lack of diversification in the marketplace. Australian smart beta portfolios generally take more stock- specific risk than their global counterparts. The return to an Australian value portfolio might depend more on specific developments of a particular company rather than what has happened to “value” more broadly. These stock-specific effects tend to wash out over time but can have a big impact on shorter-term returns. And for smart beta portfolios that rely on diversification to harness factor returns, this makes Australia a challenging universe. This argument does not invalidate the use of factors in Australia. However, investors need to be aware of the largest positions and understand how much stock-specific risk the investment is taking. MICHAEL ELSWORTH
Q I’ve heard about factors when people talk about smart beta – what does that mean and what is the difference between a single factor and multi-factors?
Factors are what drive risk and return in a portfolio. Factor investing is all about targeting these drivers. These can encompass strategies that pursue an economic or technical factor to deliver a different outcome to a marketcap-weighted strategy. There are many different factors used in ETFs, including fundamentals such as value, momentum, quality and low volatility, as well as factors such as dividend tilts and modified market cap strategies (equal weight etc). Given that single factors are cyclical and prone to periods of underperformance, multi-factor investing seeks to blend factors to reduce cyclicality and provide better balance. DUGALD HIGGINS
QIs smart beta like investing in an active fund?
All index funds, by definition, are passive investments. This includes smart beta. There’s no fund manager making investment decisions and all buying and selling is done according to a strict set of rules.
However, smart beta gives investors the ability to tilt their portfolios towards certain styles by weighting their portfolio differently. Often active fund managers have similar style tilts in their portfolios – like towards value, growth, small or large companies. Smart beta aims to combine elements of passive index investing and active fund management to deliver the best of both worlds: transparency, broad diversification and ability to tilt your portfolio to certain types of stocks, all at a low cost. CHRIS BRYCKI
Not all smart beta ETFs are designed to beat the broader market ... they merely deliver a different outcome based on their rules
Q What do I need to consider when comparing smart beta options?
When comparing, consider the factor exposure of your existing portfolio to determine what you need and your goals. Your objectives will drive which factor(s) to capture. From there, identify and group ETFs by their factor tilt (dividend, alternative weight, fundamental etc) and examine the resulting risk characteristics such as diversification, volatility and turnover levels in each ETF. Measure these characteristics against both the broader market and how they will complement (or detract) from your portfolio. Finally consider costs, both in terms of fees, trading costs and efficiency. Remember that certain factors may exhibit a low correlation with one another while others may be highly correlated. Also, while individual factors may outperform market cap strategies over the long term, they can often underperform in different shorter-term environments. Understand how factors perform in various situations to set performance expectations. DUGALD HIGGINS
Q How much should I pay for a smart beta product?
Most smart beta products track a customised or rules- based, nondiscretionary and transparent index. The amount of work involved on behalf of the issuer is not as complex or labourintensive as that of an active manager. Therefore, the starting point should be the cost of a broad-based market-cap-weighted index fund plus a small fee for the intellectual property associated with the index rules and methodology. Smart beta product fees typically range from 0.30% to 0.50% a year compared with active management fees for long-only products of 0.80% to 1.2%pa. MICHAEL ELSWORTH
Q Have smart beta ETFs performed better than index ETFs?
It’s hard to bucket all strategic beta ETFs together. There are a number of strategic beta strategies available in Australia, ranging from dividend screened/weighted to qualitydriven products. Products can also be split by asset class, though Australian and global equity products dominate the local market. Performance will vary across these groups relative to market cap ETFs as a result, and this is what we have observed. Within large cap Australian equities, for example, most dividend screened/weighted ETFs lagged their market cap counterparts over the two years to August 31, 2016. However, these products made a strong comeback as value stocks rebounded over the year to August 31, 2017, beating traditional passive portfolios. ANSHULA VENKATARAMAN
Q What are some of the bestperforming smart beta ETFs available?
Smart beta ETFs are driven by the underlying asset class as well as their strategy and factor tilt. The strongest performers tend to do best alongside their respective asset class exposures. The top five performers (by total net return) for the 12 months to July 31, 2017 are shown in the table.
It should be remembered that not all smart beta ETFs are designed to beat the broader market. They are merely designed to deliver a different outcome under the parameters of their rules-based approach. DUGALD HIGGINS
To find out why you should consider investing in a smart beta ETF, and the available strategies, visit moneymag.com.au/smartbetaquestions.