A Beginners Guide to Smart Beta Investing

Strategic-beta, commonly known as “smart beta” funds aim to either improve the return profile, or minimise risk, relative to more traditional index tracking funds and ETFs

Monika Calay 6 June, 2017 | 3:15PM
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Strategic-beta, also known as “smart beta” funds take active bets that result in portfolios that deviate from the purely market-cap-based construction of common indices, strategic-beta funds are index-linked. In that sense, they remain strictly passive.

For equities, where the bulk of the assets sit, this is how it works in practice: stocks are selected from a market cap benchmark such as the FTSE 100 or the S&P 500 when they meet certain factor-based criteria. The resulting portfolio will be tilted toward one or more factors, including value, volatility or momentum, relative to the parent index. Academic evidence suggests that certain factors outperform the broad market over the long haul.

Generally speaking, strategic beta funds fall into two main camps: return seeking and risk oriented. While return-seeking funds aim to enhance returns compared to market-cap weighted benchmarks, their risk-oriented cousins provide a smoother ride through market cycles.

Dividend, Value and Growth

The lion’s share of strategic-beta assets is in return-oriented strategies, which include dividend, value and growth ETFs. With rock bottom interest rates, it’s not surprising that investors have shunned their low-yielding bond exposure for income-oriented funds. Chief examples of dividend screened ETFs include the flagship SDPR S&P Dividend Aristocrats suite. These funds provide exposure to companies which have maintained or increased their dividends for several years: 20 for the US index and 10 for the Euro one.

In a world of heightened political uncertainty, risk-reducing strategies have grown in popularity. These funds typically track low- or minimum volatility indices. Prime examples include the SPDR S&P 500 Low Volatility ETF (LOWV), which selects the 100 least volatile stocks from the S&P 500, and the iShares Edge S&P 500 Minimum Volatility ETF (SPMV), which creates the least volatile portfolio possible using S&P 500 stocks.

Another key concern many investors currently have is stock valuations, especially in developed markets, as evidenced by increased asset flows into value-oriented ETFs. In the last twelve months, £2.2 billion flowed into value ETFs, compared to only £315 million during the previous twelve months.

Value strategies seek to exploit the “buy low, sell high” mantra. The idea is simple: they select stocks below their fundamental value and wait for the market price to eventually reflect their true worth. For example, the iShares Edge MSCI USA Value Factor (IUVF) targets the cheapest stocks from each sector in the MSCI USA Index. As a result, the ETF’s current price-to-earnings ratio of 13.5 is significantly lower than the 20.9 for the MSCI USA Index.

Beware Cyclical Factors

While value is coming back into favour, it is important to note that factors are cyclical. After the aftermath of the tech bubble, value stocks outperformed growth stocks, but ever since the second half of 2006, growth got the best of value. After ten years of underperformance, the patience of even the strongest advocates of value has been tested.

Similarly, low volatility stocks have outpaced the broader market during the past few years, as investors flocked to safer assets. But this may not continue as interest rates rise. Low-volatility stocks, like Johnson and Johnson, are defensive in nature and tend to underperform during economic expansions.

Timing factors is difficult, if not impossible, to do. Investors may need to wait for a long time before their factor-based ETF proves its investment merit.  Less-resilient investors may be better served with a multi-factor or a market-cap weighted fund.

While factors are fickle, strategic-beta funds are here to stay. This is because they offer two main advantages over actively managed funds. First, they are considerably cheaper, with an average ongoing charge of 0.38%. And secondly, they provide systematic exposure to factor premia without key manager risk. If the factor performs well, so do they. If it doesn’t, they do not. Here, only the factor is to blame.

A version of this article appeared in Money Observer magazine

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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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
iShares Edge MSCI USA Val Fac ETF $ Acc9.44 USD-0.16Rating
iShares Edge S&P 500 Min Vol ETF USD Acc92.78 USD-0.34Rating
SPDR® S&P 500 Low Volatility ETF72.63 USD0.19Rating

About Author

Monika Calay  is Director of Passive Strategies Research for Morningstar Europe

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