21 January 2016
Time for a Smart Beta Bet?
by Frank O’Nomics
Regular readers will be aware that I went into the start of this year struggling to find any asset class that offered value, and the truth is that the struggle goes on. However, it would be remiss not to acknowledge that FTSE is now 20% off its highs and hence considerably cheaper than it was. The old maxim of buying when others are selling, and the benefits of committing available investment cash when the markets are oversold, should not be understated and so the question is, how best to do this? Whether to pay the relatively high fees to an active fund manager to try to outperform the market, which involves taking some additional risk, or to buy much cheaper index-matching products which will at least ensure that you do no worse than the market overall. There is, however, also a third alternative which has the low-cost benefit of an index product, but uses empirical analysis to try to add performance beyond that of the index, so called “Smart Beta”, or Factor-based investing. Given current market volatility this may be the better way to proceed for the long-term risk-averse investor.
Typically, actively managed unit trusts, or OEICs charge around 0.75-1% per annum to mange your money, although some on-line providers will discount this to a small extent. The compound effect of these charges does have a considerable impact on the performance of your investment, particularly as the current low level of yields can restrict the extent of the income offset. In addition, by trusting in the abilities of the active fund manager you are allowing him to take risk on your behalf, as he decides on stock selection and market timing. However, if you instead put your money into an Exchange Traded Fund (ETF) which replicates the index you are targeting (whether that be the FTSE 100, S&P 500 etc) the charges are much lower, at around 0.07% per annum (so at least 10 times cheaper than an active fund), which has only a minimal compound impact on the performance of your investment over time, and you are not taking any additional risk beyond that of investing in the market overall.
The reason for the lower costs is that this fund merely has to replicate any changes to the index over time; reweighting holdings of stocks as they grow or decline over time, and adding or deleting entrants or leavers from the index, as opposed to paying for active fund manager who will require a high level of fund manger and research input. The decision to be made here is whether to put your trust in the abilities of the fund manager to outperform your chosen market (adding “alpha”), and hope that his brilliance will more than pay for the additional costs, or you take the view that you are happy to be left exposed just to the overall performance of the market (“beta”) that you favour. If your current view is that this is a reasonable time to be buying stocks you may decide to just go with the lower cost option.
So what of the “smart beta” alternative? Instead of just looking at indices based on market capitalization, it is possible to look at the different qualities of stocks and categorise them in a way other than size. For example, one can look at volatility, size (small stocks can often outperform), momentum (whether the stock has been moving up or down), growth, sector (you might want to avoid oil stocks currently for example) country and profitability. These factors are those that active mangers will look at in evaluating which stocks to buy, but rather than using stock selection one can buy an index that solely looks at, say, low volatility or high income stocks. When looking at indices based on these different criteria the performances vary widely. For example, Investec have demonstrated that, by using an index that was weighted to the 30 least volatile stocks in the FTSE 100 you could have generated a return (excluding dividends) of around 50% better (over a 10 year period) than by using one that was just weighted to the FTSE 100 itself (this EVEN 30 index is used to offer structured products).
What a number of the larger asset management groups have done is to look at the correlations between these various factors, and then look at how combining indices that are relatively uncorrelated can generate better returns over time. One of the more interesting combinations (based on performance history) is to use a combination of a small cap index (small companies tend to outperform in a bull market but do rather less well in a downturn, often due to illiquidity) and an index consisting of just low volatility stocks. Historically indices based on these 2 factors have displayed a very low correlation and, as a combination, a much more stable long-term return profile. The target of using smart beta is to reduce volatility, generate higher returns and keep costs to a minimum. The expense ratios of smart beta EFTs are typically a little higher than those in a standard market-cap based ETF, for example the iShares MSCI Emerging Markets Minimum Volatility ETF has an expense ratio of 0.25%, but this is still considerably less than that for a standard active fund.
Factor based, or smart beta investing is not nirvana for investors. By choosing an index fund based on criteria other than just market cap you are taking an active view (thereby taking more risk) and it is important to note that all of these products are “long only”, ie they do not have the facility to “go short” and hence cannot generate an absolute return when markets are trending down. They can, however, generate additional returns for a limited increase in risk and may outperform when markets are trending down. As ever the key is to decide whether the recent sharp fall in stock prices has created a buying opportunity, but if you are comfortable that this is the case then the smart beta approach may be one to consider. There are a number of providers of such products, Blackrock (iShares) and Vanguard being some of the larger ones, but a final key element that should be remembered in looking at them is that you may need to be patient.
