Smart beta is getting even smarter

Every year FTSE Russell conducts a survey to find out how smart beta is viewed by advisers and asset owners. What it has shown over the last four years is that there has been a clear shift towards greater adoption.

In the 2014 survey, 26% of respondents said they had an existing allocation to these strategies. This year, that figure had grown to 48%.

At the same time, in 2014 17% reported that they had no exposure to smart beta and did not plan to evaluate it in the next 18 months. In 2018 that figure had dropped to just 9%.

This uptake is a trend that is prevalent all over the world, including South Africa. Although inflows into funds have been relatively slow locally, there have been a number of new listings of smart beta ETFs on the JSE, and similar unit trust products have also been launched.

CoreShares MD Gareth Stobie, speaking at the CoreShares ‘Think Index Investing’ Convention held in Bryanston, Johannesburg, yesterday (June 21), noted that there has clearly been greater interest in these strategies in the past few years.

“It has been a major thrust in this industry in terms of how people are looking at portfolios and putting strategies together,” he said. “There are a number of products available in South Africa now, but we are only scratching the surface in terms of inflows.”

Alternative exposures

The interest in smart beta is driven by its ability to provide exposure to market risk factors that offer the potential for long term out-performance at low cost. These risk factors are things like value, momentum and low volatility that have persistent records of delivering better risk-adjusted returns than a pure market cap-weighted index.

“Smart beta strategies also improve diversification,” said Eric Shirbini, global product specialist at ERI Scientific Beta. “Market cap indices tend to be highly concentrated. Smart beta leads to less extreme risks in the short term, and, over the long term, higher risk adjusted returns.”

Nick Motson, associate dean at the Cass Business School in London in the UK, said that smart beta was about capturing these factors or market inefficiencies in a rules-based, transparent way.

“There is big interest in this area,” he said. “I’ve spent the last four years talking about it. It’s gone from something that didn’t exist to there being over $1 trillion tracking smart beta indices.”

The appeal for investors is that they don’t have to take a view of what will or won’t perform well because smart beta factors produce out-performance over the long term. However, the growth in this sector has caused some concerns.

More indices than stocks

“What worries me slightly is that there are over three million different stock indices,” said Motson. “There are now more indices than there are stocks. So how do you sift through that to find what you should be looking at? This is why you start to get warnings that people maybe don’t understand the risks of what they are buying and they are going to be disappointed.”

Motson pointed to research undertaken at the Cass Business School that confirmed the persistent long-term out-performance of smart beta indices over 40 years. However, over shorter time periods, their under-performance relative to a market cap weighted index could be severe.

Certain indices showed three-year rolling returns at times that could be as much as 80% below the market. This is likely too much for most investors to handle.

“Clients can’t stomach exceptional levels of volatility,” pointed out Mike Adsetts, head of client solutions at Momentum Outcome-based Solutions. “While the great thing about smart beta is that it offers low-cost ways of capturing systemic out-performance in the long run, the problem is it works until it stops working. That’s the point at which clients say I am going to jump into something else.”

Investor behaviour

This reinforces the poor investor behaviour of chasing performance. The result is invariably lower returns as people tend to buy what has recently performed – therefore buying high – and moving away from what has under-performed – selling low.

The challenge for product providers is to come up with smart beta products that show less extreme variance, while for investors, it’s important to realise that out-performance of smart beta does not come in a straight line.

“Risk factors are not a free lunch,” noted Shirbini. “By definition they are associated with bearing risks. But these risks are rewarded over the long term.”

The solution being proposed by many product providers is therefore to blend smart beta factors together in ‘multi-factor’ offerings. These use a number of different strategies such as value, momentum and quality in a single fund.

“Factors priced by the market tend to be decoupled from each other,” explained Shirbini. “When one factor is performing poorly, another will compensate. In the long term they all produce good risk-adjusted return, but a multi factor index smooths performance over the short term. For retail investors a multi-factor index is therefore a more suitable investment product.”

This is an approach being adopted locally as well.

“We have moved from a single factor approach, where we are positing single factors as alternatives to active management, to a more client-centric approach where we believe a multi-factor framework is more user friendly,” said Chris Rule, head of products and client solutions at CoreShares. “Also, in the local market, some of the risks within a single factor, such as structural biases relative to sector bets, and single stock bets, are neutralised when you utilise multi factors.”

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