How to use smart beta funds

  • Smart beta is a third way between passive and active
  • Some evidence points to their ability to outperform
  • Smart beta fund costs coming down but not as cheap as trackers

When marketers want to know what's hot, they take a look at what people are searching for on the internet. New data from Investopedia, the online investment education portal, makes interesting reading in that context: in 2015 'smart beta' was the most searched-for term by users of the site.

The growth of exchange traded funds (ETFs) is already a well-recognised trend - assets in ETFs around the world now outnumber hedge fund assets - but the smart beta phenomenon, though less well-known, is an increasingly important part of the story.


The European smart beta ETF market has been growing at an annual rate of more than 60 per cent over the past couple of years.

To see why, look no further than the stale old argument between active and passive investment supporters.

In one corner, passive fund investors argue that since most active funds routinely fail to beat the market - while charging you through the nose - it's a fool's game to pay high fees in the hope you've spotted one of the few outperformers.

Active fund managers, meanwhile, denigrate passive funds that have no choice but to robotically follow markets down even when the direction of travel is plain to see for all.

Smart beta offers a third way. It's a passive strategy, in that the fund manager still has to track a given benchmark. But the benchmark in question is one that's been actively developed - it consists of companies that meet certain criteria, according to the nature of the fund.

Investors then pick their approach on the basis of the criteria they think most suit the prevailing market circumstances.

'Smart beta is effectively a halfway house between active and passive investment,' explains Patrick Connolly, a certified financial planner at financial adviser Chase de Vere.

'The argument is that traditional passive funds with indices constructed on market capitalisation will naturally overweight overvalued stocks and underweight undervalued stocks, so smart beta attempts to use an alternative approach to market cap weightings to try and exploit market inefficiencies.'

In practice, smart beta funds come in many varieties. They might offer a benchmark comprising companies that fulfil certain valuation criteria, say, or those that meet certain earnings or income targets.

The benchmark may be weighted differently from traditional indices, which usually give proportionately more influence to larger companies.

This approach is sometimes known as 'tilt investing', because the benchmark followed is a traditional market index that has been tilted towards a particular test - the fund might invest in the 30 highest-yielding FTSE 100 companies, for example.

Other managers prefer the term 'factor-based investing', because they use benchmarks compiled on the basis of specific factors.

'Smart beta' meanwhile, is in truth an exercise in marketing hyperbole - it's supposed to convey the idea that the funds represent a cleverer way to balance the risk and reward profile of the whole market, which investment professionals sometimes describe as beta.


So does it work? Well, the statistics at first sight look compelling. A study published by passive fund specialist Vanguard last year looked at returns between 2000 and the end of 2014

In the UK, it found tilted benchmarks outperformed their traditional equivalents by around 3 per cent a year over that period; it observed an almost identical gap when looking at global indices. Other studies have drawn similar conclusions.

The counter argument is that this outperformance can be explained by the different risk profile of smart beta fund benchmarks; research suggests there is greater volatility within these indices.

In other words, investors are taking more risk in order to achieve that additional return. Vanguard itself concedes the point: 'Excess return values, after accounting for exposure to differing risk factors, have been neither consistent nor significant.'

This should remind investors of a familiar lesson: that there is no such thing as a free lunch.

Connolly puts it this way: 'There will undoubtedly be periods when all smart beta strategies produce strong short-term performance returns, but it is a real challenge to try and determine which filters will be able to provide consistent long-term outperformance.'

Nevertheless, at wealth manager Tilney Bestinvest, which has just launched a new range of multi-asset funds constructed from smart beta ETFs, manager Ben Seager-Scott insists this approach to investment is set to become more popular.

'It is important not to regard these funds as silver bullets that are somehow better than traditional trackers, because while a lot of research suggests they can deliver outperformance, there is also evidence that there can be extended periods when they will underperform,' Seager-Scott says.

'However, we do use smart beta products in many of our portfolios and are continuing to add more to our investible universe.'

For Tilney Bestinvest, the attraction of smart beta is that it delivers the lower costs of passive fund management while still allowing a more sophisticated and precise approach to portfolio construction.


Indeed, costs are coming down. On the latest launches, total expense ratios come in at around 0.25 per cent a year.

That's cheaper than many of the smart beta funds already on the market, where annual costs of 0.40 per cent to 0.70 per cent are typical, though it's still more expensive than the cheapest pure trackers, which come in at below 0.1 per cent a year.

It is, however, undeniably early days for these funds - and many financial advisers are biding their time.

For example, Philippa Gee, the managing director of Philippa Gee Wealth Management, warns: 'While I like the concept and could see myself including smart beta ETFs in portfolios to diversify the approach further, I do not believe there is sufficient choice and range to be able to invest at this point.'

That may change relatively quickly, with new products becoming available all the time and broadening a market that has until now been dominated by BlackRock-owned iShares, Invesco Powershares and State Street's SPDR.

Vanguard, for example, came to the market in December with four new funds that it describes as active ETFs.

These funds, priced at 0.22 per cent a year, track benchmarks comprising respectively of shares exhibiting value characteristics, shares with 'momentum' features, infrequently traded shares, and low-volatility shares.

These funds offer a twist on the smart beta theme, in that the fund managers have some discretion to exclude shares that the benchmark suggests they should hold - hence the 'active ETF' description.

The idea is that in addition to the rules that govern how the benchmark is constructed, managers will follow rules that help to stop them falling into traps inherent in passive management - trading too often, for example.

In fact, active ETFs, as distinct from the smart beta funds we have seen so far, are tipped as the next big thing in the market by many investors.

But that adds a further complication for investors considering these types of product, says Darius McDermott, the managing director of financial adviser Chelsea Financial Services.

'The newer funds may, for example, limit portfolio turnover and have strict rules on maximum and minimum stock and sector weightings,' he says. 'But this is becoming more and more like active management and you will need to consider whether that is what you want.'


Choosing smart beta funds is more challenging than picking conventional passive investments, where the cost of exposure to a given index is the clinching factor.

Investors need to decide which type of benchmark style they want exposure to, and then which manager offers the best option for getting that exposure; no two managers aim to deliver 'value' or 'momentum', say, in the same way.

'It's essential that investors really get to grips with how a given smart beta product operates - look at the rule set that a given product uses, and think about the consequences of those rules,' says Seager-Scott.

'For example, a typical momentum strategy might do well in trending markets, but when markets turn it could significantly underperform; conversely, quality factors can be defensive when markets are challenged, but tend to underperform in strongly rising markets when investors look to take advantage of cheap companies that have been oversold.'

The iShares FTSE UK Dividend Plus ETF is often seen as a good starting point for smart beta investors, while Seager-Scott picks out the manager's pan-European fund range as 'providing low-cost exposure to particular factors, with rule-sets that are very sensible'.

Other advisers suggest FirstTrust's AlphaDEX fund range, which has been available in the UK for more than three years, and Lyxor SG Quality Income, which also has a three-year track record and is part of the Société Générale fund stable.

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