Smart Beta … you better know about it!

Significant innovations in the funds management industry are few and far between. When they take off they can make a huge difference to those investors who are on the bandwagon early. Think ETFs, or stapled securities, or the glorious early days of hedge funds.

With low-growth markets the order of the day, anything that can boost returns is going to get a lot of attention … it’s time to learn about ‘smart beta’.

To understand just what it is you’ll need to know about fundamental indexing (more on this later), but for now it’s enough to say that smart beta refers to a new approach to enhancing the returns from tracking indices.

Smart beta moves away from the traditional approach of concentrating on the market capitalisation proportions of index constituents and opens the formula out to include a range of key performance indicators, including dividends and volatility.

One of the most common smart beta techniques is to ignore simple techniques of matching market weightings of different stocks and instead to load the fund according to each company’s key characteristics: sales, cash flows and dividends.

In a way, it’s a hybrid between ‘active management’ and pure quant-based index fund investing championed by brands such as Vanguard. Interestingly, the fees charged by smart beta funds are also a hybrid, being higher than index funds but lower than actively managed funds.

State Street Global Advisors estimates the funds flowing into smart beta funds are growing by 45% per annum. Already there is an estimated $142 billion in global smart beta funds, including two Australian-based funds – Colonial’s ‘REAL Index’ fund and BetaShares’ ETF under ASX stock code QOZ.

What is “fundamental” indexing?

The academic breakthrough that has triggered this wave of ‘smart beta’ activity is fundamental indexing, which was pioneered by Rob Arnott, a US academic turned investment manager who in the early 2000s realised that traditional index funds – for all their benefits – had a major flaw: an inevitable over-exposure to stocks which are over-priced.

For example, if BHP’s total dollar value (measured by its share price times the number of shares on issue) is (say) 10% of the total value of the ASX 200 index, then BHP’s weighting (proportion) will automatically be 10% of the ASX 200 index.

Once the index is initially calculated and invested in, the relative weighting over time of each component is self-correcting: as BHP’s share price rises and falls (thus changing the relative weighting within the index), its proportional value within the index tracking portfolio will also change. The only turnover or re-balancing in a “market capitalisation” weighted index is when a stock is taken-over, de-listed or its size falls and it falls out of the index.

Fundamental indexing takes a different approach to compiling an index. Instead of using market capitalisation as the definitive measure of a stock’s economic size, fundamental indexing uses a small number of simple accounting metrics to build the index. In the Rob Arnott approach (known as “Research Affiliates Fundamental Indexing” or “RAFI”), measures of company size like cash flow, sales, gross dividends, and share price to book value are used to compile the index.

The RAFI approach was designed to address the problem of market “noise” – i.e. when share prices are more volatile than is justified by changes in a company’s fundamentals. Arnott’s thinking was stimulated by the Tech Bubble – where speculative tech stocks boomed to 25% of cap-weighted index exposure by 2000 (up from 8% in 1995). When the prices of these stocks collapsed in the “Tech Wreck”, the damage flowed into traditional index funds – compared to RAFI style indices where tech stocks had only risen to 10% in 2000 (up from 6% in 1995).

The performance of the RAFI style index compared to the traditional market cap weighted index in Australia can be seen in the chart below.

Click to enlarge

Smart Beta 2.0 – the next generation

For all of its simplicity and potential for outperformance, the RAFI approach has its own critics – based on the use of accounting measures to compile the fundamental index. Although these measures are normally robust and accurate, they are of necessity historical (and may be up to a full year out of date) and open to gaming by unscrupulous management. To overcome these potential problems, other first generation alternative index approaches have developed, including indices which:

• Reduce exposure to stocks experiencing high volatility (and increase exposure to stocks in periods of low volatility);
• Work in reverse, by increasing exposure to high-volatility stocks (a more aggressive approach) and reduce exposure to lower-volatility stocks;
• Implement an equal dollar weight allocation to stocks;
• “De-concentrate” portfolios by reducing allocation to large stocks and increasing allocation to smaller stocks;
• Take account of liquidity of stocks, to reduce the portfolio costs incurred through index re-balancing (noting that fundamental style indices are periodically re-balanced as their fundamentals change – instead of the far less frequent re-balancing that occurs for traditional market cap weighted indices);
• Focus on specifically desired characteristics, like dividend growth, or momentum.

A wide range of ETFs which use various combinations of these smart beta indices are now available in Europe and the US, including the:

• Russell Defensive 1000;
• MSCI High Dividend Yield;
• FTSE Active Beta Momentum & Value;
• MSCI Risk Weighted;
• MSCI Minimum Volatility;
• S&P 500 Equal Weighted;
• FTSE EDHEC – Risk Efficient.

These smart beta indices can be seen to outperform both the market cap weighted, and RAFI style indices – although the “narrower” the index is, the more likely it is that outperformance will be more pronounced in some market conditions (with potential for under-performance compared to simpler indices in other market conditions).

This provides for a wider menu of choice for investors, as well as an increased need for tools to help select and optimise individual investor’s choices.

Indeed, it seems this ‘new thing’ is already being challenged by an elaboration known as “Smart Beta 2.0” championed by the European university think tank EDHEC/Risk Institute. Smart Beta 2.0 is a way of unbundling the IP developed by first generation fundamental indices (such as RAFI), and the index enhancements mentioned above. Smart Beta 2.0 offers a range of portfolio construction tools to help investors understand what market conditions are best suited to specific index styles. You can view these tools at: http://www.scientificbeta.com .

The ASX is no doubt keen to expand the range of smart beta indices available through its product platform. Interested readers can listen to Rob Arnott’s recent webinar for the ASX (click here).

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals. He provides asset consulting and financial product services but does not receive any benefit in relation to the product reviewed. Twitter: @TonyRumble.