The buzz around smart beta funds is growing worldwide as investors look for a nuanced alternative that brings together the benefits of actively managed funds and passively managed funds (see my articles on the advantages and disadvantages of passive investing for some background). Smart beta funds aim to beat the market by blending elements of active and passive strategies.
These funds usually track a particular index – for example, the FTSE100 or the S&P 500 – but try to boost returns by adjusting the allocation according to parameters like risk and volatility. For example, stocks in a smart beta fund may be weighted in proportion to fundamentals, such as revenue, dividend rates, earnings, and price-earnings ratio or book value. By contrast, a passive fund tracks the composition of a particular index with a weighting based on market capitalisation.
The surge in smart beta funds is driven by the wealth of data we have about the world’s major stock markets and the growing interest in algorithmic investment strategies. The idea is to use data in a rules-based manner to exploit inefficiencies in the market and deliver returns that outstrip the benchmark (as active funds seek to do) while preserving the low management costs of a passive fund.
As with active and passive funds, smart beta instruments have their own pros and cons:
- Versatility: Smart beta funds offer choices for a wider range of investment strategies and goals than passive funds – for example, investors can pursue higher-risk, higher-reward strategies or seek higher dividend income.
- Reduced exposure to expensive, large-cap stocks or sectors: The technology sector on the S&P 500 makes up nearly a quarter of its market capitalisation and some large tech shares are looking expensive; in South Africa, Naspers, Richemont and BHP Billiton constitute 41.3% of the market capitalisation of the JSE Top 40!
- Smart beta funds could incorporate assets with a small market capitalisation that have more upside potential than the large-cap stocks or shares. They also allow for diversification of a portfolio into sectors where there may be more growth potential than the in market-capitalisation weighted indices where key components have already run hard.
- Cheaper than active funds: Smart beta products have lower management fees than active funds, paired with the potential to outperform the market.
- Transparency: Smart beta allocates assets in a rules-based and transparent way, giving visibility into what the investment is doing and which assets underpin its performance.
- Smart beta is in its infancy: The market is still evolving, with new products coming to market all the time. Most funds don’t yet have long actual trading histories, but those that promise higher returns than the market may also carry higher risks.
- Overwhelming choice: The rapid growth of smart beta means that investors can choose between hundreds of indices that pursue different investment goals and that use a wide range of factors and rules to allocate assets. Choosing one may take some careful research from professional advisors.
- Higher management fees than passive funds: Smart beta funds usually have higher expense ratios, portfolio turnover and rebalancing costs than passive funds.
An evolving market
The rise of smart beta is an example of how technology is going to disrupt the investment space in the years to come. We’ll see ever more sophisticated smart beta products come to market and their popularity will continue to grow. Though they do not replace active and passive funds, they offer further opportunities for investors to balance and diversify their portfolios, and have a role to play in a well-managed portfolio. In my final article in this series, I’ll talk about our investment philosophy at Dynasty and how we use a combination of smart beta, passive and active strategies to maximise returns and minimise risks.
By Ryan Page, Director at Dynasty Private Wealth and Asset Management