Smart beta funds: the best of both worlds, or not worth the fees?

Passive funds tracking bespoke indices biased to specific market factors have gained traction. Are they worth the extra cost, asks David Prosser.

What do you call a passive fund that isn’t so passive? If you’re a marketing guru charged with selling more asset management products, you come up with a scientific name and pitch your fund as a sophisticated new solution for the problems of our times. Meet the smart beta phenomenon.

The investment industry began selling smart beta funds a decade or so ago, but sales have really taken off over the past three years. Bloomberg figures suggest global inflows into smart beta funds rose from $56 billion (£42 billion) in 2016 to $84 billion last year, with BlackRock estimating that the industry is now worth as much as $2 trillion in assets under management.

The appeal is easy to understand. Many investors grew frustrated with traditional actively managed investment funds years ago, with studies repeatedly showing that such products levy high charges but tend to underperform the markets in which they invest. Equally, however, the passive funds to which investors have turned instead have their problems too. Low-cost they may be, but in replicating the performance of a given stockmarket index, they blindly expose investors to the rollercoaster ride of equity market volatility. Over the past year or so, that’s been pretty hairy.

Smart beta funds are designed to offer a middle ground. These funds still passively track a given benchmark, but the fund manager actively develops that benchmark (or picks one actively developed by someone else) so it is tilted towards particular types of stock. You might choose a smart beta fund tracking consistent dividend-payers, low-volatility stocks, or shares offering a value play, for example.

Breakthrough year

David Mann, head of capital markets, global exchange traded funds at asset manager Franklin Templeton Investments, thinks this idea is about to become even more popular with investors, predicting that inflows into smart beta products will top $100 billion for the first time during 2019.

“I think 2019 will be the breakthrough year,” argues Mann. He says investors are increasingly nervous about the way in which large companies dominate traditional stockmarket indices (which are weighted by market capitalisation) and, therefore, the funds that track them. “Given the choppy markets we have seen recently, many smart beta exchange traded funds have outperformed – sometimes significantly – their market-cap equivalent ETF.”

Certainly, smart beta fund managers spy an opportunity, and the market has seen a series of new launches over the past year. Not only are there more funds offering tilts towards market factors – value, growth potential, momentum and income, for example – but there have also been launches bringing smart beta ideas to particular investment themes, from technology to environmental, social and governance (ESG) investment. iShares, for example, launched the Sustainable Core Range, while Lyxor is offering the Global Gender Equality ETF.

Does reality match theory?

The big question, of course, is whether the reality of smart beta lives up to the theory – and here the jury is still out. The biggest long-term study of smart beta investing, conducted by Vanguard, one of the leaders in the field, appears to show it working well. The study found tilted benchmarks outperformed their traditional equivalents by around 3 percentage points a year over a 15-year period.

However, the same study also showed investors in those benchmarks would have experienced more volatility – in other words, taken more risk to achieve their higher return. Plus you need to choose the right type of tilt or factor for the prevailing market conditions: different types of smart beta fund have delivered better or worse performance at different times.

Nevertheless, a number of financial advisers do now see a role for smart beta funds in the portfolios of some investors. Tilney Investment Management, for example, now uses a variety of smart beta products in portfolios it selects for clients. “No single investment approach, whether data-, process- or judgment-driven, is infallible – but used effectively, factor funds do have the potential to enable investors to outperform general market returns, without incurring the higher costs of active management,” argues Tilney managing director Jason Hollands.

Martin Bamford, the managing director of independent financial adviser Informed Choice, is also a fan. “Being slightly selective in stock selection and following a rules-based approach should give investors an edge over the market as a whole,” he argues. “If this can be delivered at a very low cost, it provides a good alternative to index trackers or actively managed funds.

Others are less convinced. Ben Willis, head of portfolio management at financial adviser Chase de Vere, worries about the difficulty of choosing the right smart beta fund, as well as the cost of the products.

“There is no guarantee you will make the correct calls, and smart beta funds are often significantly more expensive than traditional passive funds,” he warns. “We believe that for most investors, the best and most cost-effective way to get broad-based exposure to an index or asset class is by using a conventional low-cost passive fund based on market capitalisation.”

In the background, meanwhile, the academics are also lining up in the debate over the efficacy of smart beta. In one corner stand the likes of Adriana Robertson, an assistant professor at the University of Toronto, whose recent paper on passive funds is turning heads throughout the investment community.

Robertson argues that so much work goes into constructing the indices tracked by traditional passive funds that this style of investment isn’t passive at all – plus, she points out, the benchmarks are constantly tinkered with. In effect, the investment decision-making responsibility has simply been transferred from investors and fund managers to the firms that manage the indices.

If that’s the case, shouldn’t fund managers take back control of the thing they’re getting paid for? Smart beta funds offer exactly that opportunity, since it’s the manager who develops the index, according to the tilts and factors to which they’re looking for exposure.

Hang on a minute, say smart beta critics. A report from Research Affiliates warns that back-testing of smart beta funds may have been selective, with fans of the concept simply assuming – perhaps wrongly – that the strong historical record of certain types of tilt is inextricably linked to the nature of those factors.

Highlighting the risks

Similar research from ERI Scientific Beta is harder hitting. Entitled Misconceptions and Mis-selling in Smart Beta, it argues that many smart beta fund managers don’t do enough to highlight the risks their products carry. For example, they fail to point out that the strong performance identified in backtesting may simply have been a result of the prevailing market conditions, rather than the fund’s mandate and management.

Whichever side you take, it’s clear that smart beta is no free lunch. Indeed, Chase De Vere’s Willis is not alone in identifying the sector’s higher costs. Data published by Morningstar last year found that the typical smart beta fund was priced at around 0.37% a year; that looks reasonable compared to actively managed funds, but you can find many traditional passive products with significantly lower fees.

Sometimes, though, the smart beta premium may be worth paying. In 2018, when stockmarket volatility spiked upwards after a period of calm, low volatility smart beta funds significantly outperformed more traditional trackers, Morningstar analysis reveals. Equally, however, income-focused smart beta funds took a dive around the same time. One reason for the markets’ volatility last year, particularly in the US, was speculation about higher interest rates, and that lessened the attraction of higher-yielding shares.

The contrasting fortunes of these two styles of smart beta underlines another point investors should bear in mind: while traditional passive funds are often seen as a low-maintenance vehicle for long-term exposure, smart beta may require more intervention. “These funds are aimed at investors prepared to actively adjust their portfolios and express market views, rather than those who just want to buy and hold,” warns Hollands.

What the experts recommend

Which smart beta funds do financial advisers like in today’s market? Jason Hollands of Tilney says they can work especially well in the US, where active managers find it difficult to add value and where concerns about the sustainability of the high valuations of the big technology companies are a worry.

“We like the Invesco FTSE RAFI US 1000 ETF, which owns the 1,000 largest US stocks but weights the basket on four factors (revenues, cash ow, dividends and net assets),” Hollands says. “We also like SPDR S&P US Dividend Aristocrats, which invests in stocks that have increased their dividend every year for 20 years – a select group of 106 companies.”

Alternatively, in the income space, Ben Willis, though not a fan of smart beta in general, says he does like the Schroder US Equity Income Maximiser fund. “This fund tracks the S&P 500 and targets a 5% income,” Willis explains.

For a more international approach, Martin Bamford suggests the iShares Edge MSCI World Momentum Factor ETF. “This has a low ongoing charge of 0.3% and offers exposure to a subset of global equities that have been experiencing an upward price trend,” he says. “There’s a strong evidence base behind momentum investing, so this to me is preferable to blindly investing in all global equities via an ETF or index tracker.”

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