Will Smart Beta change the face of investing forever?

Slowly but surely, American influences have permeated the social fabric of the UK. From the takeover of our high streets by McDonald’s franchise outlets in the 1990s to R&B music and the rise of Apple technology in the 2000s, we have embraced ideas originating from across the Atlantic.

In financial services, we are beginning to see the charge of so-called ‘robo-advisers’ – services that aim to offer automated, regulated advice at a lower cost – and the rise in prominence of cheap exchange-traded products designed to track, or mirror, the performance of a certain index, basket of stocks or asset class.

To that list of imports we can add Smart Beta, an innovation that some believe will revolutionise investing in the UK by bringing the power of active fund management to the masses, at a fraction of the cost.

But what exactly is Smart Beta (also confusingly referred to as ‘factor investing’, ‘advanced beta’, ‘alternative beta’, ‘strategic beta’, and ‘beta-plus’)? How does it work? And can it really add value to clients’ portfolios over and above existing tracker and active offerings?

Halfway house

UK investing has historically been split broadly between active and passive strategies. On the active side, fund managers attempt to combine in-depth research on companies, sectors and regions with stock-picking skill to generate returns for investors.

Exchange-Traded Products (ETPs), on the other hand, offer flexible and transparent exposure to a variety of different asset classes and markets at a much lower price.

One of the major criticisms of traditional tracker funds has been their over-exposure to the larger companies that make up an index. This is because asset allocation tends to be based on the market capitalisation of the firms within the index, meaning investors could end up holding large chunks of their portfolio in a single sector or company.

Smart Beta attempts to overcome this market-cap bias by using various factors, depending on the preference of the investor, to determine how much of each asset in a particular index the fund should hold.

Some Smart Beta products will simply swap the market-cap approach for equal-weighting, so no single stock in an index has undue influence on the performance of the fund as a whole. Others will use screening tools so asset allocation is based on one or more other factors, such as value, momentum, dividends, volatility and so on. As a general rule, the more of these factor screens a fund applies, the closer it will resemble an active fund and, unsurprisingly, the higher the price.

The major providers currently active in the UK Smart Beta market include WisdomTree, State Street and iShares, among others.

The Evidence

In the US, passive exchange-traded funds have become increasingly popular among investors wanting market exposure at minimal cost. Assets in US ETFs passed the $2trn mark in recent years, with over 1,400 funds offered to investors. Morningstar reckons assets under management in European exchange-traded products more than doubled between 2009 and 2014, reaching $362bn in September 2014.

Smart Beta has been one of the fastest-growing segments of the US ETF market, rising from nothing at turn of the millennium to around $200bn in assets at the end of 2014, according to Bloomberg Intelligence.

However, the jury is still out on whether these factor-based, halfway-house strategies really deliver better risk-adjusted returns than their passive and active counterparts.

In a 2015 study entitled ‘How Smart are ‘Smart Beta’ ETFs’, Denys Glushkov of the University of Pennsylvania analysed the performance of 164 US equity Smart Beta ETFs between 2003 – 2014.

While the paper found that 60% of Smart Beta fund categories had beaten their raw passive benchmarks, Glushkov concluded: “…I find no concrete empirical evidence to support the hypothesis that [Smart Beta] ETFs outperform their risk-adjusted benchmarks over the studied period.”

Others have highlighted concerns about performance claims based on ‘backtesting’. This is clearly open to manipulation as firms can build factors into a product to ensure it would have done well based on historic market performance.

In addition, it’s worth noting the average cost of Smart Beta funds was also 70% higher than traditional cap-weighted ETFs (0.41% vs 0.24%), according to Glushkov’s study.

Useful tool in the armoury

While such analysis might give investors pause for thought, it should not mean Smart Beta is simply dismissed out-of-hand.

Smart Beta has, to date, polarised opinion, with some viewing it as a challenge to the established order in active investment management, and others as simply a way for ETF providers facing margin squeeze to boost their bottom line.

The extra choice provided by Smart Beta strategies – sitting as they do somewhere between active and passive management – makes them a useful tool in investors’ armoury. However, you need to be aware of both the potential risks and benefits before investing.

These types of strategies take simple passive investing that tracks well known indices to a new level by specifically focusing on companies that exhibit certain characteristics. And while traditional ETFs can become overly exposed to a few large stocks in an index, Smart Beta allows investors to equally weight stocks so small and large-caps have exactly the same influence on overall performance.

But it should be remembered that by investing in a way that is different to a traditional index, you are increasing the likelihood that you will perform differently to the index.

By focusing in on a specific style, you have the chance of outperforming the traditional index if this style performs well - but of course the flip side is that you can significantly underperform the traditional index if the style falls out of favour.

It is also worth remembering that Smart Beta strategies are more expensive than traditional passive strategies and investors will need to determine before investing whether this additional cost is worth paying. And when investors herd to a particular factor – volatility being an obvious one right now – the price will inevitably leap as a result.

Additionally, in times of turmoil, investors might find that liquidity in these products is not what they hoped for, particularly if they are looking at smaller Smart Beta strategies from newer entrants in the market.