The risks and rewards of the new breed of tracker funds

Smart beta can no longer be ignored, but investors need to understand exactly what they are investing in, according to Thesis Asset Management’s Steven Richards.

Tracker funds have historically focused on companies based on their size – the FTSE 100 index of the largest 100 firms in the UK, for example, or the S&P 500 index of the 500 largest US businesses.

But the danger of following these indices is that they can be heavily concentrated in one sector or company.

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HSBC, for instance, accounts for 7 per cent of the FTSE 100, and some 18 companies in the index are in the oil and gas industry. This can have a major effect on performance.

For example, the S&P500 index posted a slight positive return for 2015 partly because of the 80 per cent average gain between Facebook, Amazon, Netflix and Google (FANG). Had the FANG four not performed so strongly, the S&P500 would have posted a loss.

For all their mainstream use, market cap indices are now facing a challenge. Fund groups are working to develop new trackers known as ‘smart beta’ indices. These trackers can help investors have more control over what they’re investing in and can be built based on risk levels or yield requirements, rather than just blindly following a stock market.

NOT AS CHEAP AS NORMAL TRACKER FUNDS

While they are not as cheap as basic trackers, many are cheaper than investing in an active fund, and they can be more effective too.

Certainly, within equities, practical experience has shown that active managers who outperform the market may not necessarily do so because of their ability to pick individual stocks, but more because of the process they use to identify these stocks.

Investors may therefore be better investing in a smart beta fund to access this style at a cheaper cost. The remainder of their fee budget can then be used for a greater allocation to, say, alternative assets, which are less replicable in tracker format.

There are certain characteristics of outperforming stocks which go a long way to explain their performance such as value, size, low volatility, quality, yield and momentum. Smart beta indices therefore try to isolate these factors so that investors may gain exposure to these drivers of outperformance versus market cap weighted indices.

LOOK UNDER THE BONNET

But investors need to be aware that these factor indices may have crossover themselves. A stock within a yield index could also be in a low volatility index, for example, so it’s important to check the holdings of a tracker just as you would an active fund to make sure you are not over-exposed to a particular stock or sector. 

There is no doubt that investors are increasingly using smart beta products. Last year in a FTSE Russell survey of global institutional investors, nearly three-quarters of respondents said they now either invest in or are considering smart beta index-based strategies for their portfolios.

Thesis itself has recently invested in a smart beta fund (the UBS FTSE RAFI Developed 1000 Index fund) that favours companies that sit in the value corner of the market – oil producers, telecoms, banks, classic tech giants, pharmaceuticals and the like. Notable omissions include Amazon, Facebook and Alphabet. So, while some of the names are not drastically dissimilar to more common indices, the isolation of exposure to these companies and the way they are weighted has met the requirement we were looking for – it gives us a noticeable ‘tilt’ towards so-called value stocks but avoids deeply cyclical names.

With the rise of smart beta indices investors are getting stuck into a growing range of products and using them to build more sophisticated portfolios. Decisions still need to be made about markets and whether they are overvalued or undervalued. Traditional, cap-weighted indices will still form the wider basis for measuring and quoting market movements. Indeed, we captured the FANG effect through a simple market weighted tracker, but should the FANGs ever likely be down, there are smart beta products to avoid this.


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