Investing basics: what's so 'smart' about smart beta ETFs?

Almost two decades ago, they asked us to wrap our head around exchange traded funds. And while admittedly it took us a while, we did it.

Then they asked us to get behind active ETFs, and we did that too. Actively managed funds in a tradeable structure, great.

Now, a new exchange-traded product innovation in Smart Beta ETFs.

Whoa, wait. Have I been buying "dumb" investment products up until now?

Don't worry. "Smartwater" didn't make regular water any less essential.

Smart Beta ETFs can be thought of as a hybrid approach that combines the strategic advantages of active management with the lower investment costs offered through indexing.

Instead of a stock-standard market cap index determining the make-up of an ETF, or a professional investor stock picking and market timing, Smart Beta ETFs use engineered algorithms, computerised company assessments and a carefully crafted screens for stocks.

Smart beta ETFs are gaining in global popularity. Globally, there are 1493 strategic-beta ETPs, with collective assets under management of about $797 billion.

In Australia, the smart beta ETF market stands at $4.2 billion, or 10.5 per cent of the ETF market.

Australian ETP Assets (in USD billion)

Source:  Morningstar Direct, Morningstar Research. Data as of 12/31/2018

Advocates say that strategic beta funds are low-cost entryways to specific investment tilts that were previously available only through higher-priced actively managed funds. Some financial notables, including investment expert and author Rick Ferri, think these funds can be useful if understood and used correctly. Others, such as the late Vanguard founder Jack Bogle, view strategic beta funds with scepticism.

In this article we're going to explore where the "smart" in "smart beta" comes from, what these products deliver, and how they can fit into your portfolio.

Why are Smart Beta ETFs a thing?

You probably already have some familiarity with index-based investing, in which a managed fund or exchange-traded fund simply tracks the performance of a specific market index. The most widely used indexes - like the ASX 200 or the S&P 500 - are capitalisation-weighted, or cap-weighted, meaning that they, and the funds that track them, allocate holdings based on each company's market capitalisation - the market value of a publicly traded company's outstanding shares. Thus, bigger companies make up a bigger percentage of the portfolio, while smaller companies make up a smaller share.

Critics of cap-weighted index funds point out that they force shareholders to own more shares of stocks that are overpriced while owning fewer shares of those that are under-priced.

You also might be aware of active investing, where a fund manager deliberately picks and chooses specific investments (such as stocks) they believe will perform better or be less risky than other investments.

However, critics say many managers charge investors hefty fees for poor performance.

What are Smart Beta ETFs?

To avoid these issues, but also as a way to manage risk in a portfolio, some investors have turned to indexing strategies that ignore market cap in favour of other factors such value, dividends, low-volatility, momentum and quality.

In a sense, factor-based indexing mimics strategies that many active fund managers use. But rather than a human deciding on which stocks to buy and sell and when based on his analysis, factor-based indexing automates the process by applying a model that determines what goes in the portfolio. This makes them "smart".

This eliminates the need for an active manager and thus helps reduce fees, though factor-based funds and ETFs still tend to charge more than market cap-weighted index funds and ETFs. You might think of factor-based indexing as a hybrid approach that combines the strategic advantages of active management with the lower investment costs offered through indexing.

The "beta" component in strategic beta comes from how the investment responds to swings in the market, and the desire to catch more of the upside, and less of the downside, says Andrew Clee, vice-president, ETFs, at Fidelity Investments Canada.

Strategic beta comes from more than 40 years of academic research that has looked at both why investments give investors returns and the role that risk plays in the equation, says Art Johnson, founder and CIO at SmartBe Wealth. The theory is that by removing human behavioural biases, cutting through the noise and avoiding concentration risk of companies in an index, you’ll have the kind of beta that beats both active and purely passive bets.

How are Smart Beta ETFs constructed and managed?

Like a passive investing approach, a smart beta ETF tracks an index. But it isn’t your everyday index. In some cases, it’s a factor-based index, such as a value index, created by an independent index provider. But in a practice, that is becoming more frequent with the rise in popularity of strategic beta ETFs: it’s a custom-designed index just for a specific product that has been engineered by quantitative analysts.

Once the product has been launched with the bespoke index, it’s hands-off from humans (until the next rebalancing). This quantitative approach results in “a product that behaves as it’s designed,” says Clee. The design that goes into these indexes often involves a filtering process through a universe of companies to isolate stocks that provide the desired level of exposure to the factors that the index is designed around.

For example, Fidelity’s process “first defines a universe of around a thousand stocks to start,” says Clee, then selects companies with attributes that enhance exposure to a given factor followed by a screen for quality-assurance, picking out stocks that might be suspect and ensuring there is no concentration risk among too few companies.

A human element remains, however, in that there will be a need to pick the right factors to follow, at the right time.

“Factor investing is science if there is fair reason to believe that a manager can identify factors with a positive expected alpha—until the factor becomes a crowded trade and the expected excess return flips to negative,” writes Larry Siegel, director of research at the CFA Institute Research Foundation, in an article for Morningstar magazine. “It’s hard to see how any factor can work forever”.

Some examples of Smart Beta ETFs listed on the ASX

A total of 33 smart beta ETFs are now listed on the ASX, according to Morningstar. These include:

VanEck Vectors MSCI World ex Australia Quality (QUAL) delivers a portfolio of high-quality global equities. QUAL tracks the MSCI World ex-Australia Quality Index – a subset of the broader MSCI World ex Australia Index. This benchmark targets firms with high return on equity, stable earnings growth, and low financial leverage.

BetaShares FTSE RAFI Australia 200 ETF (QOZ) offers diversified exposure to Large-Cap Australian Equities. The strategy tracks the FTSE RAFI Index, a concept pioneered in the US by Research Affiliates in 2005 and initiated in the Australian market by RealIndex in 2008. The index holds the top 200 Australian equities measured by equally weighting four metrics: five-year profits, dividends, cash flows, and recent book value.

SPDR MSCI Australia Select High Dividend Yield ETF (SYI), a way to capture exposure to high-dividend-paying Australian shares. SYI’s portfolio closely resembles the benchmark, the MSCI Australia Select High Dividend Yield Index. The customised benchmark applies a rules-based dividend overlay that has delivered above-market yield and franking.

What's Morningstar's take on Smart Beta ETFs?

For investors looking for a way to home in on specific factors when managing their portfolios, or just for a way to replicate an active management strategy in a cheaper, index-based product, smart beta or factor-based funds are certainly worth a look. However, as with any hot investment trend, it's important not to get swept up in the hype. Some of the strategies used by factor-based funds and ETFs are rather complex, and if you don't have a good understanding of how they work or how the investment is designed to perform, the smart thing to do may be to steer clear.

Contibutors to the piece include Andrew Willis, content editor for Morningstar.ca, and Adam Zoll, assistant site editor with Morningstar.com.