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Smart beta moves to centre stage

Smart beta is revolutionising the way investors build portfolios.

Globally, smart beta is the fastest-growing segment of the investment management industry and Australia is also experiencing this trend. At the forefront of this growth are smart beta exchange-traded funds (ETF), which have recently moved from the periphery to a mainstream investment option.

In August, almost 70 per cent or $197 million of total Australian ASX exchange-traded product (ETP) flows was invested in smart beta and active ETPs.

Investing in smart beta

Smart beta ETFs combine active and passive management by tracking indices that deliver a chosen investment outcome, while retaining low cost, transparency, liquidity and ease of trading. Traditionally, ETFs have followed conventional market capitalisation weighted indices, however, this trend is rapidly changing as investors increasingly use smart beta ETFs to achieve specific portfolio outcomes.

ETFs that track smart beta indices do so by holding the shares that are in the index and only changing their portfolio when the index changes. There are different types of smart beta indices, some of which are outlined below:

· Equal weight – all constituents are given an equal weighting regardless of their market capitalisation. Components of equal weight indices are often selected from a universe of stocks based on market capitalisation before being equally weighted. Equal weighting may be applied at the individual stock or sector level.

· Factor based – all securities selected are based on factors such as quality, dividends, momentum, low volatility or a combination of these. Combinations may be weighted by factors or by market capitalisation or a combination of these. Components of factor-based indices are often selected from a universe of stocks based on market capitalisation before screening is applied.

· Capped weight – individual stocks cannot exceed a maximum percentage of the index. Components of capped weight indices are often selected from a universe of stocks based on market capitalisation before the capping is applied.

· Fundamentally weighted – the proportion of each constituent is based on the company’s value using economic and accounting fundamental factors instead of price. Fundamental factors include total assets, sales, cash flows, number of employees or a combination of these and other factors.

· A combination – some indices use a combination of the above with a qualitative overlay, such as the Morningstar Wide Moat Focus Index, which equally weights the most attractively priced United States companies that have passed Morningstar’s proprietary Wide Moat screen.

Over the past five years, the number of smart beta ETFs listed on the ASX has increased from five to 29. In 2011, there was $250 million invested in smart beta strategies on the ASX that predominantly focused on equity income. Today, there are a number of different smart beta strategies, which total in excess of $2.1 billion in assets, confirming the incredible growth of smart beta investing in Australia.

A new survey on smart beta investing by VanEck found over 90 per cent of financial professionals would consider investing in smart beta strategies in the future and 89 per cent believe smart beta will outperform or perform in line with an actively managed fund.

Almost three-quarters of surveyed respondents who already use smart beta strategies currently use at least two or three across factor or multi-factor exposures, fundamentally weighted, equal weighted and dividend screened or weighted. Most respondents use smart beta strategies for either Australian or international equity exposures.

The CFA Institute recently reported smart beta products — by carving out a significant component of active management and offering it more cheaply and more transparently — will disrupt the business of active management. In particular, “active management will evolve into two separate product types: smart beta products with lower fees and pure alpha products with higher fees”, it said.

It is evident investors are increasingly focusing on alternative index weightings to seek higher returns for the same or even less level of risk. Smart beta indices can remove the distortions that are present in traditional market capitalisation strategies, which can significantly impact on performance, particularly during market volatility.

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