DIY Investor Magazine
/
December 2015
56
A Smart Beta ETF aims to deliver the best of both
worlds – to beat the market or to match it while taking
less risk - precisely what an active investing product
would hope to do, yet they follow an index and deliver
the advantages of passive investing.
Smart Beta ETFs exploit investing anomalies that
are known to have beaten the market over the long
term – finding companies that are undervalued, highly
profitable or with a long track record of outperformance
and creating an index that filters out those that do not
fulfil those criteria. A passive ETF buys each of the
components of an index such as the FTSE All-Share in
proportion to their relative market value and delivers the
returns of the market – a simple, low cost process.
By contrast, a Smart Beta index that tracks, for
example, undervalued companies will apply a formula
to the market index in order to up weight stocks
that look cheap and down weight those that seem
expensive; it aims to beat the market by holding
more of the types of securities that have historically
outperformed and tend to be more expensive than
passive trackers.
In the same way that equities beat cash and bonds
over time because investors expect to be rewarded for
investing in riskier assets, academics have discovered
securities which outperform their peers because they
are more risky or because they somehow confound
human behaviour, causing them to be undervalued.
Specially developed formulae identify these special
security categories which are known as investing styles
or factors and underpin Smart Beta ETFs.
Five factors that have outperformed the market
historically are:
VALUE
– unglamorous firms, with volatile dividends and
high earnings risk are often underrated by investors; a
value firm’s comparative cheapness can be a source of
strong future returns.
WHAT IS A SMART BETA ETF?
SMALL CAP
– smaller companies are riskier than
large cap ones because they’re more vulnerable to
misfortune; investors expect a greater investment return
in exchange for taking on greater risk.
QUALITY
– companies that make efficient use of their
capital tend to outperform over time when, for example
R&D pays off; investors often underrate quality firms
because their spending can make them look like they’re
underperforming now.
MOMENTUM
– rising stocks tend to keep rising for a
limited period, while losing stocks continue to fall as
investors over-react and under-react to news.
LOW VOLATILITY
– large, non-cyclical companies
such as utilities that deliver market-like returns but
for significantly less risk and show resilience during
recessions. By taking on these risks, investors expect
to be rewarded with greater returns when economic
conditions and sentiment cause individual factors to
bounce back.
Value, Momentum and Small Cap have done well in
times of economic growth and rising inflation and
interest rates, whereas Quality and Low Volatility have
been defensive and delivered outperformance in
downturns.
New investors should understand that the Smart Beta
promise of market-beating returns will not necessarily
come true and you may have to endure years of
underperformance before your investment pays off.
However, the main factors listed above have been
shown to work across multiple countries, asset classes
and decades which is why Smart Beta has become so
popular.
Better still, some of the factors have low correlations
with one another, so the underperformance of one can
often be offset by the outperformance of another. For
example, value is known to have low and even negative
correlations with profitability and momentum.
ETFS AT A GLANCE
