Smart beta tracker funds: a beginner's guide

Strategic beta funds, commonly known as smart beta, aim to either improve the return profile or minimise the risk pattern relative to more traditional index-tracking funds.

While they take active bets, resulting in portfolios that deviate from the purely market cap-based construction of common indices, strategic beta funds are index linked. In that sense, they remain strictly passive.

For equities, where the bulk of assets sit, this is how it works in practice: stocks are selected from a market cap-based benchmark such as the FTSE 100 or the S&P 500 indices when the stocks meet certain factor-based criteria. The resulting portfolio is therefore tilted towards one or more factors, including value, volatility or momentum, relative to the parent index. Academic evidence suggests that certain factors outperform the broad market over the long haul.

Two main camps

Generally speaking, strategic beta funds fall into two main camps: return-seeking and risk oriented. While return-seeking funds aim to enhance returns compared with market-cap weighted benchmarks, their risk-oriented cousins provide a smoother ride through market cycles.

The lion’s share of strategic beta assets is in return-oriented strategies, which include dividend, value and growth ETFs. With rock-bottom interest rates, it’s not surprising that investors have shunned low-yielding bond exposure for income-oriented funds. Chief examples of dividend-screened ETFs include the flagship SDPR S&P Dividend Aristocrats ETF suite. These funds provide exposure to companies that have maintained or increased their dividends for several years: 20 for the US index and 10 for the euro version.

Another key interest for many investors currently is stock valuations, especially in developed markets, as evidenced by increased asset flows into value oriented ETFs. In the past12 months £2.2 billion flowed into value ETFs, compared with just£315 million during the previous 12 months.

Value strategies seek to exploit the ‘buy low, sell high’ mantra. The idea is simple: they select stocks below their fundamental value and wait for the market price to eventually reflect their true worth. For example, the iShares Edge MSCI USA Value Factor (IUVF) targets the cheapest stocks from each sector in the MSCI USA index. As a result, the ETF’s current price/earnings ratio of 13.5 is significantly lower than the 20.9 for the MSCI USA index.

In a world of heightened political uncertainty, risk-reducing strategies have also grown in popularity. These funds typically track low- or minimum-volatility indices. Prime examples include the SPDR S&P 500 Low Volatility ETF (LOWV), which selects the 100 least volatile stocks from the S&P 500 index, and the iShares Edge S&P 500 Minimum Volatility ETF (SPMV), which creates the least volatile portfolio possible using S&P 500 stocks. 

Click the table below for a larger version:

Cycling challenge

However, it is important to note that factors are cyclical. Thus, in the aftermath of the tech bubble, value stocks outperformed growth stocks, but since the second half of 2006, growth has had the better of value. After 10 years of underperformance value is coming back into favour, but the patience of even the strongest advocates of value has been tested.

Similarly, low-volatility stocks have outpaced the broader market during the past few years as investors have flocked to safer assets. But this may not continue as interest rates rise. Low-volatility stocks – Johnson &Johnson, for example – are defensive in nature and tend to underperform during economic expansions.

Timing factors is difficult, if not impossible. Investors may need to wait a long time before their factor-based ETFs prove their investment merit. Less resilient investors may be better served with a multi-factor or market-cap weighted fund.

While factors are fickle, however, strategic beta funds are here to stay. This is because they offer two main advantages over actively managed funds. First, they are considerably cheaper: theongoing charge is0.38 per cent on average. And secondly, they provide systematic exposure to factor premia without key manager risk. If the factor performs well, so do they. If it doesn’t, they don’t. Here, only the factor is to blame.


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