Smart Beta – As smart as it sounds?

Imagine an investment that promised to consistently outperform a benchmark without large management fees. A process that was automated to eliminate human error, but still acted under the guidance of human decision making. With smart beta exchange traded funds, or etfs as they are colloquially known, providers such as Research Affiliates, Blackrock and WisdomTree are promising their customers that it’s possible to have your cake and eat it too.

The term “smart beta” has become ubiquitous amongst investors today given its astronomical growth in the etf industry. Indeed, its prevalence today can be attributed to the explosive cocktail of conceptual simplicity, effective marketing and demand for alternative investments. With the recent continued outperformance of passively-invested tracker indices versus their actively managed counterparts, investors have become increasingly more dubious of parking their money with actively managed funds charging higher management fees and a cut of the profits.

At its core, a smart beta etf is any rules based index whose constituents are not weighted by market cap, as is commonly the case with the majority of equity indices, but rather by any other methods. The most common of these are to equally weight all the constituents in an index, weight based off over lower volatility, or single/multi-factor based weights from the fundamentals of the constituents. These can vary from anything as simple as more heavily weighting low volatility stocks, advanced tail risk mitigation through the purchase of options to counteract any unforeseen bear market swings.

The logic behind the creation of smart beta etfs lies in the fact that as an investor, it is irrational to increase holdings, or more heavily weight a company as its stock price increases given that the cost of purchasing the security increases, as well as having returns tending to peak as investors sell off the now overvalued company. Instead with a smart beta etf, a specific strategy, or set of strategies can be followed with systematic rebalances merging the benefits of passive investing by ignoring the white noise of human, whilst still retaining a touch of active management through the selection of factors and value investing by screening the fundamentals of the constituents. The first two smart beta funds were launched by iShares in 2000, following the factors of growth and value. Since then, the total market value industry has grown aggressively from just over $100 billion in 2008 to over $500 billion this year.

Smart Beta fund assets hit new highs year on year. Source: Bloomberg

How has this relatively new instrument captured the hearts and minds of today’s investor?

The benefits include –

Straightforward: Through factor based investing, customers of smart beta etfs are able to mix and match a number of funds to diversify their portfolio, as well as take a position on what factors they expect to generate the greatest returns going forward.

Managed risk: Given that the constituents will be tied to a major equity index, the “beta” guarantees a level of tracking correlated to the vanilla index’s return.

Lower costs: the systematic rebalancing alongside factor based investing make smart beta etfs cheaper in cost to traditional actively managed funds.

However, this investment isn’t without its pitfalls. The risks associated with smart beta investing include –

Lower Liquidity: Due to the custom nature of, the influx in different smart beta funds has made entering and exiting these funds become harder than selling a traditional tracker fund.

Overcrowding: This occurs when there is a mass of investor inflow into a particular etf, resulting in the strategy becoming overused. Whilst it may artificially inflate prices in the short term, there are fears of a bubble forming through the continued purchase of overvalued stocks based on the strategy.

Transactions fees: As smart beta funds weight their constituents differently from traditional trackers, they may buy into stocks that have smaller AVAT than the largest market cap stocks, leading to higher transaction costs for execution.

Indeed, Rob Arnott, the founder of Research Affiliates whose RAFI smart beta funds are amongst the most invested globally has admitted as recently as last year that smart beta investing “could go horribly wrong”. Sold on the idea of making riskless profit, the dangers of overcrowding loom ever closer with each investor that pumps money into an already popular smart beta etf. With this, Mr Arnott believes that the smart beta bubble is due to burst shortly, with investors facing a sobering three to five years of depressed returns.

Robert Arnott predicts Smart Beta returns to sour in the near future. Source: Financial Times

Smart Beta succeeds as another tool by which an investor can take a position in the market based off of factors, yet the aforementioned pitfalls represent significant risk to capital as is the case with any investment. As part of an overarching strategy, smart beta etfs can be combined with existing holdings for diversification and a method of enhancing returns through the circumvention of market inefficiencies.

Despite its recent surge in popularity, smart beta funds are not the cash printing machines many a naïve investor would believe them to be. As is so commonly touted as a disclaimer to any financial investment, past performance is no indication of future gains. It should come as no surprise that the world of smart beta is hardly different.

Key Insights –

– Smart Beta ETFs: Alternative rules based indices weighted using a methodology other than traditional market-cap weighting.

– 20% of all ETFs in the US, with 450 actively listed funds with an aggregate $510 billion in market value. (as of Sept 2015, Morningstar)

– Risks include overcrowding through investors buying into the same fund/strategy, lower liquidity than standard etfs leading to higher trading costs.

By Mark Yoshihiro Strzepek
EMEA Portfolios & Risk, Bloomberg

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