‘Smart beta’, a new weapon in your armoury

May 24, 2013 5:55 pm

‘Smart beta’, a new weapon in your armoury

By David Stevenson

No longer a straight choice between active and passive investing, says David Stevenson

The term “smart beta” doesn’t exactly roll off the tongue. Nor is it likely to become a catchphrase, as in: “I’ve made an absolute killing on my smart beta funds.” But smart beta is something investors could be hearing a lot more about in the years ahead.

My colleague Merryn Somerset Webb outlined the structural limitations of the fund management industry last week.

Basically, most managers are doomed to hug the benchmark because the industry is focused on gathering assets. Better to fail conventionally than to succeed unconventionally, as Keynes said. Passive investing might reduce the costs, but invariably commits you to a momentum investing strategy because most indices are weighted by market capitalisation. The bigger a company gets, the more you have invested in it. Over time, the noise of the market will even out the rises and falls of individual shares and you’ll get the underlying market return, also known as the beta of the index.Smart beta takes the idea of simply investing in that benchmark index and adds a twist or two. The smart beta eggheads have spent many years looking at which particular strategies or individual measures have helped deliver superior returns when compared to a conventional benchmark index.

There are many different ways to construct an index based around the 100 largest companies on the London Stock Exchange, and market capitalisation doesn’t have to be the only measure to sort stocks in an index.

If you want an insight into some of the ideas that have been backtested and turned into indices, go to www.scientificbeta.com, a new website run by European investment research organisation called EDHEC Risk. Click on their flagship indices and you’ll find an academic description of all the strategies, along with the results of backtesting since 2002. It all sounds very exotic and complicated, with names such as the US Value Maximum Deconcentration index or the Developed Low Volatility Maximum Deconcentration index.

Stick with indices and trackers that aren’t horribly complex black boxes and that are easily understood and cheaply implemented

– David Stevenson

The term “deconcentration” comes up frequently. It effectively means an index where there’s a lot of diversification between the companies and not much concentration in just a few top stocks based on market capitalisation. The easiest deconcentration strategy of all is to buy all the constituents of an index in equal portions, rather than by market capitalisation.

Low volatility is another popular smart beta idea. It entails ranking all the stocks in an index such as the FTSE 100 based on their recent share price volatility and then either exclude the most volatile, or give the biggest weightings to the least volatile shares. The idea is to get equity-like returns but with fewer wild gyrations.

Value and dividend measures are also popular. Screening according to yield, price-to-book ratio or some other measure of fundamental value should ensure that investors own more of the most undervalued shares.

Once you’ve decided which strategy suits you best, you can go to a resource such aswww.whichetf.co.uk and use their exchange traded fund screener to find some of these smart beta trackers using the “focus” filter. You can then tell the screener to look for low-volatility trackers (there are some, provided by Ossiam and iShares), or dividend-focused trackers (lots more ETFs in this space including ones from nearly all the major issuers).

It’s still early days for the smart beta revolution, so it’s hard to say any one strategy is the best, but I would offer only one bit of advice based on my own experience. It is to stick with indices and trackers that aren’t horribly complex black boxes and that are easily understood and cheaply implemented. For that reason I think investors should consider equally weighted indices; in rising stock markets, you should outperform the index because equal-weighted indices give greater prominence to mid- and small-cap companies, which tend to rise faster in bullish markets.

I’m currently thinking about including some equal-weighted US index tracking funds from db x-trackers and some European ones from Ossiam to my own portfolio – if I do, they’ll then sit alongside my existing holdings, which include the State Street SPDR UK Dividend Aristocrats ETF (this targets high-yielding stocks where the dividend has been growing over time) and the SG Quality and Income Index. This pulls together a number of smart beta ideas, including low volatility, high yield and measures of balance sheet strength.