According to research consultancy ETFGI there was $680 billion invested in smart beta exchange-traded products (ETPs) globally by the end of January this year. Although this is only around a fifth of the assets invested in traditional market-cap weighted index trackers, the smart beta category is growing much faster.
Over the past five years, ETFGI calculates that smart beta ETPs have grown their assets at a compound annual growth rate of 33.1% per year. For the same period, market-cap weighted ETPs have grown at 20.9%.
Smart beta refers to those strategies that select and weight shares based on criteria other than only their market capitalisation. They include approaches that focus on areas such as dividend yield, value, quality, equal weighting, momentum and low volatility.
There are a number of reasons for the growing popularity of these strategies. A FTSE Russell survey of investment advisors in the UK, US and Canada last year found that the main reasons for including them in portfolios are generating income, capturing alpha, improving diversification and downside protection.
Increasingly, it is the last two of those reasons that are getting the most attention. This is because funds that track pure market-cap weighted indices do not provide any risk protection. Particularly in highly concentrated markets, such as the JSE, this can be a significant issue.
As index strategies have developed, however, more emphasis has been placed on how this can be addressed.
“I could use the analogy of the motor vehicle industry,” says Roland Rousseau of RMB Global Markets. “Thirty years ago it took a very important and different path when safety became the differentiator. Cars might be 50% faster than they were 30 years ago, but they are 10 times safer.”
Similarly, managing risk has become a much bigger focus in portfolio construction. A major reason for this is a better understanding of just how difficult it is to beat the market.
“Let’s assume that we can’t outperform the market,” Rousseau says. “And there is lots of evidence to say that it’s very hard to do, whether you are using active processes or smart beta processes or risk premia. Is there still something we can do to improve the investors’ experience? The answer is there is a huge amount we can do if we rather focus on lowering portfolio risk.”
Blending styles together
Until recently, smart beta strategies tried to do this only through offering exposure to one investment style or ‘market factor’. Examples in South Africa include the Satrix Rafi, which is a value approach, as well as the CoreShares Low Volatility and NewFunds Equity Momentum ETFs.
More recently, however, asset managers have been looking at blending different strategies together in multi-factor products that not only emphasise diversification but also pay a lot of attention to how portfolios are put together. It’s an approach that has resonated with a lot of investors.
According to BlackRock, last year more money flowed into multi-factor strategies than any other smart beta approach. This shift is also now gaining recognition in South Africa.
CoreShares recently announced that it intends to introduce a multi-factor ETF to replace its Equally Weighted Top 40 product. The NewFunds Volatility Managed ETFs that listed last month also use a multi-factor approach for their equity exposure.
What these multi-factor strategies do is offer investors exposure to more than one of the smart beta styles or ‘market factors’ within a single product. Instead of being just value or quality or momentum offerings, they combine them to deliver even better diversification and risk management.
Risk and return
The reason they have become popular is that while smart beta strategies provided answers to some of the concerns presented by pure market-cap weighted products, they have created others of their own. Firstly, while they offer diversification away from market-cap indices, they are not necessarily that well-diversified themselves. And secondly, the investment styles they use are cyclical, and some of them can be volatile.
Value is an obvious example. While well-accepted academic research shows that value will outperform over time, this style has underperformed the market quite dramatically at some points over the last few years.
Investing in single style or factor funds therefore introduces an issue of timing. Because they are cyclical, they tend to reinforce bad investor behaviour – buying at the top and selling at the bottom.
Multi-factor funds look to address this by giving investors exposure to more than one style, which leads to a much smoother return profile. This is because, in times when one factor is underperforming, one of the others should be delivering positive returns.
Investors can think of this working in much the same way that multi-asset, or balanced funds, do. While balanced funds allocate to different asset classes to reduce volatility and capture returns from different places, multi-asset funds do something similar with the different factors they use.
These strategies also generally pay a lot of attention to how their portfolios are constructed and how they manage risk. They will not have a large exposure to any one share or market sector, and will therefore generally offer the best diversification of any index strategies.
To use Rousseau’s analogy, they are not just offering airbags and anti-lock braking systems, but sensors and traction control as well. They allow continual diversification without the need to forecast where the market is going. What you end up with is something that delivers similar market performance, but with the least amount of adverse returns if something unexpected happens.