"Smart Beta ETFs are not a universal cure for underperformance."
Smart Beta Blog
As the investment environment evolved and we entered a world of lower returns and uncertain global economic outlooks, professional investors have begun to move away from traditional active investing to alternative strategies, known as smart beta. How are proponents of smart beta faring in terms of returns and costs, against traditional investment managers?
A smart beta investment strategy aims to add value by strategically choosing, weighting and rebalancing the companies built into an index based upon a particular factor or factors e.g. value stocks or growth stocks or less volatile stocks or other factors. Smart beta applies a series of objective, rules-based screens to each index’s component company according to the specific smart beta factor/s being applied. In contrast, traditional market-cap weighted indexes, e.g. the FTSE 100 or S&P 500, simply weight their constituents based solely on market caps, giving larger companies a bigger slice of the index.
Smart Beta, may not be perfect but in 2016, applying predominantly common sense strategies, they compared highly favourably against traditional active managers.
New research conducted at SCM Direct reveals that whilst smart beta ETFs are by no means perfect, they can be a much better investment choice than traditionally managed active funds.
SCM Direct analysed a sample of 72 £ denominated, London Stock Exchange Listed Smart Beta equity ETFs that were available to invest in throughout 2016.
The total assets within these funds was £19.4 Bn.
The average fund size was £269m, with the largest analysed being the £2.2 bn SPDR S&P US Dividend Aristocrats fund.
Performance — Smart Beta ETFs beat Human Active Fund Managers in 2016
Research into active fund stock picking performed in 2016 has found that the majority performed poorly , with 2016 seeing UK fund management companies having suffered their worst year since the start of the financial crisis, with just 21% beating the market in the 11 months to the end of November.
Whilst SCM Direct is cynical about the fees and methodology of some smart beta funds, our research findings show that smart beta performance outperformed their human counterparts in 2016; with the average Smart Beta ETF outperforming a traditional market cap weighted benchmark by 1.5%.
However, it should be noted that choosing the best smart beta ETF was critical, as by number, just 56% of the smart beta ETFs analysed beat a comparable market cap weighted benchmark.
Top 10 within the Smart Beta ETF sample analysed by SCM Direct
Bottom 10 within the Smart Beta ETF sample analysed by SCM Direct
Fees — Smart Beta ETFs charge half traditional active funds — 0.39% pa vs 0.9% pa
The FCA in its recent Asset Management report found that the annual average disclosed fee for managed equity funds available to UK investors was 0.90% per annum and the average passive fee was 0.15% per annum.
Whilst the average fee of the smart beta ETFs is double the traditional market cap weighted ETF, it is still half the fee of a traditional active manager.
Diversification — Smart Beta ETFs are less diversified than many market cap weighted index funds
The average smart beta ETF in the research sample held 268 stocks as compared to the average number of index constituents within the S&P 500, FTSE All-Share, MSCI World and MSCI Europe indexes being 798.
The average concentration (measured as the %age in the top 10 holdings) of the smart beta ETFs was slightly more than the market cap weighted index equivalents being 26% vs 20%.
In terms of a link between diversification and performance, it was interesting to note that the average outperformance of the smart beta ETFs holding 100 or fewer stocks was 0.4%, whilst the average outperformance of those holding more than 100 stocks was 2.1%.
Smart Beta ETFs are not a universal cure for underperformance. However, whilst their charges are significantly higher than a plain vanilla index fund (0.39% vs 0.15%) many follow proven strategies e.g. size, quality, momentum, value etc. that tend to outperform over the long-term.
In addition, investors would know what they are getting as the smart beta ETF will stick to its strategy rather than be tempted to panic and change their strategy, often at precisely the worst time — known as ‘style drift’.
However, there are drawbacks. Many of the smart beta funds are more concentrated in terms of stocks and sectors than their market cap weighted alternatives, and their performance can differ dramatically (both positively and negatively) from the index over shorter time periods.
Higher concentration can risk the overall smart beta factor being negated by a handful of stocks disappointing or by the extra costs associated with higher fund turnover.
Also, as our 72 ETF sample showed in 2016, stock picking is required to evaluate the timing as to when the valuation and fundamentals associated with the smart beta strategy is most opportune. For example, many value tilted ETFs have benefited in 2016 from the sharp upswing in value stocks across the world post the Trump victory which may not be sustained through 2017. By number, just 56% of the smart beta ETFs analysed beat the comparable market cap benchmark in 2016.
Some smart beta companies have somehow persuaded advisers and private clients that smart beta is the investment nirvana. But the 2016 performance range of up to 17% less or 39% more than the traditional market cap weighted index, shows there are no guarantees even from smart beta ETFs.
Many investors may not want to take on this extra year to year performance risk, even if eventually their chosen smart beta strategy may well pay off.
So even with smart beta strategies, the old investment rule of if it seems too good to be true, it probably is, still applies.