What is a Smart Beta ETF?

These products are touted as sophisticated and seemingly magical approaches to outperforming the market, at a fraction of the cost of active funds

Morningstar Canada 25 March, 2019 | 3:32PM

TargetsEarlier this month, Morningstar.co.uk looked at the growth of strategic or smart beta ETFs, and how these funds are growing in popularity. UK analyst Kenneth Lamont looked at how dividend strategies are still dominant. Morningstar Inc director of passive research Ben Johnson, in his overview of the global smart beta market, said that at the end of 2018, there were 1,493 strategic-beta exchange-traded products, with collective assets under management of approximately $797 billion worldwide.

But what is a smart beta ETF and how does it work? They have often been described as a blend of active and passive funds, with the outperformance of the former and the lower fees of the latter.

These products are touted as sophisticated and seemingly magical approaches to achieving alpha, or outperforming the market. These products are often managed around the idea of factors such as value, dividends, low-volatility, momentum and quality, and their historical association with higher returns.

A strategic beta product invests in the companies which provide exposure to the factors that are basis for the product’s investment approach. The product obtains the factor exposures by applying a set of mechanical rules so that human judgement is not involved once the rules are in place.

Strategic beta is the second dominant approach to active management, says Art Johnson, Founder and CIO at SmartBe Wealth. People are familiar with the first approach – involving humans – which involves a stock picking manager whose job is to beat the market for their customers using market timing and her or her own skills.

Mixture of Active and Passive

Remove some of that human element – the day to day management, personal stock picking and market timing attempts – and replace it instead with engineered algorithms, computerised company assessments and a carefully crafted screen for stocks, and you have something that lands between the realms of active and passive management.

The "beta" component in strategic beta comes from how the investment responds to swings in the market, and the desire to catch more of the upside, and less of the downside, says Andrew Clee, Vice President, ETFs at Fidelity Investments Canada.

Strategic beta comes from over 40 years of academic research that has looked at both why investments give investors returns and the role that risk plays in the equation, says Johnson. The theory is that by removing human behavioural biases, cutting through the noise and avoiding concentration risk of companies in an index, you’ll have the kind of beta that beats both active and purely passive bets.

“There is a ton of evidence that stock picking doesn’t work that great and neither does market timing, but there is lots of evidence that you can beat the market by holding certain variables or characteristics – and by holding them you can do better than a market cap index,” says Johnson.

The ability to outperform an actively managed approach, as well as a passively managed broad index approach is enticing. These approaches are also much more cost-effective than their active counterparts, but pricier than purely passive plays because of what goes into the index that they track.

Similar to a passive investing approach, a strategic beta tracks an index. But it isn’t your everyday index. In some cases, it’s a factor-based index, such as a value index, created by an independent index provider. But in a practice that is becoming more frequent with the rise in popularity of strategic beta ETFs, it’s a custom-designed index just for a specific product that has been engineered by quantitative analysts.

Filtering Process

Once the product has been launched with the bespoke index, it’s hands-off from humans – until the next rebalancing. This quantitative approach results in “a product that behaves as it’s designed,” says Clee. The design that goes into these indices often involves a filtering process through a universe of companies to isolate those stocks that provide the desired level of exposure to the factors that the index is designed around.

There is still a human element that remains, in that there will be a need to pick the right factors to follow, at the right time.

At the investor level, “not all factors are ‘one-size-fits-all’”, adds Clee, saying that the investor’s personal situation plays an important part in the factor selection process. Some investors require income and should focus on the dividend factor. Others might have longer time horizons and have the potential for higher returns with a momentum focus.

Investors should also pick the right factors for the market.

“Factor investing is science if there is fair reason to believe that a manager can identify factors with a positive expected alpha—until the factor becomes a crowded trade and the expected excess return flips to negative,” wrote Larry Siegel, Director of Research at the CFA Institute Research Foundation, in an article for Morningstar magazine. “It’s hard to see how any factor can work forever”.

Clee adds that investors should anticipate that a strategic beta approach will differ from a benchmark – hence the beta – and that they should adopt a goals-based lens, for this goals-based solution.

Both Clee and Johnson agree that it’s important to know whether you’re making big bets you might not be aware of. “They require more active due diligence,” says Clee. Many strategic beta products have too much of the market in them because the manufacturer thinks clients won’t like something that looks too different from the index, Johnson adds.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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