Is 'smart beta' really smarter than ETF?

Australia’s offering of exchange-traded fund products is no different, with a growing number of products now available on the stock exchange that are adding flavour to the blander, so-called “plain vanilla” ETF securities that simply aim to achieve “beta” (the market return) by buying all the stocks within a market index.

Plain vanilla ETFs weight their holdings according to the market capitalisation of the companies within an index, which often means they are overweight in the bigger stocks that are more expensive and underweight in smaller ones that are less popular and generally underpriced. Such ETFs, after taking into account their entry costs and fees, have tended to underperform.

Which is why more and more ETFs, including those listed on the Australian Securities Exchange, are employing investment strat­egies that the technical financial boffins and asset managers describe as “smart beta”.

What is smart beta?

First developed in the US, smart beta ETFs go beyond the basic market capitalisation methodology of traditional index-following funds and structure their stock weightings not on price but ­according to fundamental multi-factor metrics such as a company’s sales, cash flow, book value and dividend payments.

The US-based firm credited with having founded the smart beta discipline, Research Affiliates, says the smart beta investment approach is aligned to a company’s economic footprint and seeks to exploit market inefficiencies by anchoring on factors other than price.

(Technically, “alpha” tells you how well a security is doing compared to a stated benchmark — it indicates the excess return of a fund; and “beta” tells you how volatile an investment is compared to the overall market.) “In other words, smart beta strategies break the link between price and portfolio weight in an effort to deliver better-than-market returns.”

By reducing weightings in the most expensive stocks, which usually have a sizeable impact on the performance of an index, smart beta funds promise enhanced portfolio returns and reduced risk at a low to moderate cost.

A major report on smart beta indexing this year by FTSE Russell found that “the smart beta phenomenon has matured to the point that large numbers of asset owners now consider smart beta indexes to be an important part of the investing toolkit”.

BetaShares managing director Alex Vynokur, who oversees two fundamentally weighted smart beta ETFs listed on the ASX — the BetaShares FTSE RAFI Australia 200 ETF (QOZ) and BetaShares FTSE RAFI US 1000 ETF (QUS) — says the strategy is a very disciplined, index rules-based approach that aims to deliver better performance.

“Smart beta provides low cost, transparency and efficiency but also improves performance by removing the link with an index,” Vynokur says, adding that for Beta Shares’ QOZ product, stock rebalances have resulted in investors outperforming the ASX 200 on average by 2 per cent per annum.

“There is the opportunity to achieve outperformance at the cost of an index fund. We’re finding in Australia that investors are finding smart beta is a way of achieving alpha (the measure of a portfolio manager’s performance), but paying for beta.”

Just poor alpha?

While the fees associated with smart beta products, including administration, expense recoveries and brokerage, are typically lower than those of actively managed funds, there is a growing voice of opinion they’re not overly cheap when compared with market capitalisation-weighted index funds.

Others question smart beta funds’ performance in general, and note that market index creation firms are increasingly being engaged by ETF issuers to build bespoke indices upon which their financial products can be moulded. “They’re not real indices, and the issuers are then charging a lot for market-led algorithms that are based on back-tested data but which won’t necessarily work in the future,” says a financial products expert. “It’s an accident waiting to happen.”

He’s not alone. Among other detractors is Research Affiliates’ co-founder Rob Arnott, who in a February article, “Beware of rising valuations in smart beta”, warned that a “stampede in popularity” was pushing up the prices of some smart beta funds to bubble proportions.

“Is the financial engineering community at risk of encouraging performance chasing, under the rubric of smart beta? If so, then smart beta is, well, not very smart,” Arnott wrote.

“It’s dangerous to ignore relative valuation outright, and to go ahead and load up on a factor just because its past performance has been brilliant.”

Lessons for investors

Jonathan Ramsay, a director of Sydney-based ETFs portfolio construction firm InvestSense, says that many of the products available now in Australia are income focused, and have underperformed the market.

“There seems to be a tendency for factor/smart beta ETFs (and sector-based ETFs) to be launched following strong performance by the factor (sector), which may expose investors to the risk of subsequent underperformance. This has been noted in overseas markets where there is greater availability of ETFs, but it is especially prevalent among the limited number of predominantly income/dividend focused products in Australia,” says Ramsay.

“On the other hand, there is some evidence that active income products have performed just as poorly recently, as the world ­started to think about the possibility of higher interest rates.”

He adds that investors should think carefully about what the total return expectation of the smart beta ETF might be.

“In the case of dividend/income-focused ETFs, the thought should be, ‘Can I accept the downside’?” Ramsay says. “High-income payers should theoretically underperform over the long term.

“Sometimes it might be better to wait through one cycle and have a tendency towards a factor that hasn’t necessarily delivered outsized gains in the recent past, but where you think the future looks brighter.”

Vynokur says that, fundamentally, investors should not just focus on ETF performance but the methodology behind the product.

“I would caution investors that they really understand the merits of the methodology and that it’s not just a back-tested model that doesn’t relate to the realities of the investment world.

“We, as a business, do not necessarily take the view that one way of indexing is the Holy Grail.”