How smart beta strategies work
Smart beta is a term many advisers will have read about and many may already invest in smart beta products on behalf of their clients, but there is more to it than many advisers think, explains Andrew Francis.
There is now more than $140 billion in funds under management globally invested in smart beta strategies and a quick Google search brings an amazing 139 million results for the term. So what is smart beta and what is all the fuss about?
What is smart beta?
Traditional stock market indexes are based on market capitalisation weightings; for example, the S&P ASX 200 in Australia, the S&P 500 in the US and the FTSE 100 in the United Kingdom.
The market capitalisation weight (or market cap weight) of a company is calculated as the number of shares on issue of the company multiplied by the current share price.
For example, Commonwealth Bank of Australia has 1.6 billion shares on issue; its closing share price on 21 January 2014 was $76.10 which gives it a market capitalisation of $121 billion. Its weight in the S&P ASX 200 is then its market cap divided by the total market cap of the top 200 ASX listed companies (free float adjusted).
Market capitalisation weighted indices were originally designed to measure a market’s return. In the US the S&P500 was launched in 1957; however it was not until the mid-1970s when Batterymarch and Wells Fargo, two US investment firms, launched index funds.
Since then, indexing has grown in the US to account for approximately 27 per cent of all equity funds under management, and while active managers had outflows of $386 billion from 2008-2013, index funds gained $667 billion.
Their popularity has been due to a number of advantages: lower costs and fees, transparency, large investment capacity and lower turnover.
However, it relies on the belief that markets are perfectly efficient, with price a good proxy for the fair value of the company.
However, if you believe that markets are not perfectly efficient, as Realindex Investments does, then weighting by price can cause a market cap index to be overweight to overvalued companies and underweight to undervalued companies.
When there is mean reversion in prices this can cause a long-term return drag on a cap weighted index portfolio.
Think of NewsCorp in March 2000 at the peak of the tech media and telecoms boom. Its weight in the S&PASX 200 was 16.45 per cent when its share price was at a then all-time high, only to fall to a weight of 7.5 per cent 18 months later.
Or for Finnish investors where Nokia made up 80 per cent of the weight of the local Finnish stock market index; how many people have a Nokia phone today versus 13 years ago?
How smart beta strategies work
Smart beta products weight by non-price weighted measures, rather than weight companies by market cap.
This may be fundamentally weighted (such as sales, cashflow, dividends), equally weighted (putting the same amount of money in each company) or lower volatility (weighting towards less volatile companies).
A smart beta process should be systematic and replicable and try to capture the benefits we discussed about traditional indexes. Smart beta strategies typically rebalance (buy the losers and sell the winners) back to these non-price weighted measures.
A number of whitepapers have shown that breaking the link with price and portfolio weight can add an extra 2 per cent return to a client’s portfolio; even randomly generated portfolios outperformed the market cap index.
The common trait with smart beta strategies is that they will have some element of a value tilt (ie, buying cheaper companies) and/or a small company tilt when compared with the market cap index which tends to be growth and momentum-oriented.
So what’s the catch?
The pattern of returns of smart beta strategies will vary to that of the market cap index, so it is important that investors understand that these strategies can and will under-perform the cap weighted index and have a patient long-term mind set.
Further, some smart beta strategies may not be as liquid and others may have higher turnover. As such it’s important that investors understand the smart beta strategy they are buying.
That said, for patient investors the reward for well-constructed, lower cost, liquid and lower turnover smart beta strategies is the potential for longer term outperformance. It’s worthwhile taking the time to research, understand in greater detail and add to client portfolios where appropriate.
Andrew Francis is the chief executive officer of Realindex Investments.
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