What is smart beta?

Key takeaways

  • Smart beta funds are low-cost equity funds that follow rules like other index-tracking funds.
  • Instead of investing in the market in line with the weighting of certain shares, smart beta funds target certain factors in the market that are known to deliver returns higher than those the entire market delivers.
  • Factors that can deliver higher returns are those that identify shares with value, momentum, quality, low volatility and a smaller market capitalisation characteristics.
  • Factor or smart beta investing introduces the risk that you may underperform the market if the factor to which you are exposed does not deliver returns over the period for which you are invested.
  • Investing in funds with exposure to more than one factor can lead to smoother returns than investing in a single factor.


Smart beta or enhanced passive is a halfway house between passive or index-tracking investing and active investing. 

The simplest passively managed investments are those which track an index that is weighted in line with the size of the shares on the market – a market capitalisation index, such as the FTSE/JSE All Share index for the JSE.

But a disadvantage of these passively-managed investments is that they will always slightly underperform the market after fees are deducted.

Market research, however, has identified that shares with certain common characteristics – known as factors – are exposed to investment risks that deliver good returns in a market.


Harnessing factors

Managers have developed passive investments with rules that identify and invest in these shares, with a view to delivering returns that beat the market.

Using rules to identify the relevant shares gives a portfolio a tilt towards a “factor” in the market.

Smart beta or enhanced passive funds are therefore said to use factor-based investing. They are also referred to as alternative beta and the process as strategic investing.

Smart beta investments are typically offered by index-tracking investment managers as unit trust funds and the fund description should alert you to the fact that the fund takes more investment risk than an index fund that tracks a market capitalisation index.


Mimicking style

Identifying shares that constitute a factor is similar to the process a manager uses when adhering to an investment style. Smart beta funds can therefore be said to mimic investment styles.

As smart beta funds follow rules to capture returns above the market, they are described as “systematically harvesting” the alpha that an active fund manager targets when following a style.

As smart beta funds use rules or systems rather than analysts and research, their fees are typically lower than those of actively managed funds. The charges may be slightly higher than that of index-tracking funds that follow market-capitalisation indices as the rules-based system is more expensive to set up.

As smart beta indices become more widely available, the costs reduce.


What factors are harnessed

The factors that can deliver market-beating returns have been identified after many years of research of many different markets around the world. Only a handful of factors have been identified.

The factors that deliver market-beating returns have been identified as:

The value factor: funds targeting this factor have rules that allow them to invest in shares that have low prices relative to the break-up value of the company.

The momentum factor: funds targeting this factor have rules that allow them to invest in shares that have been performing well and are likely to continue to do so.

The quality factor: funds targeting this factor will have rules that allow them to invest in shares characterised by low debt, stable earnings growth and high profitability.

Low volatility: funds targeting this factor will have rules that allow them to invest in shares with lower-than-average volatility.

Small cap: funds targeting this factor will follow rules that identify the shares of smaller companies relative to others listed on an exchange.

 

IDENTIFYING FACTORS

Smart beta funds use the certain measures to identify shares that display the characteristics of a factor. For example:

Value factor shares are identified on the basis of their price relative to the company book value, their earnings relative to the share price, their net profit, dividends or cash flow. Some funds focus only on dividend yields the share has delivered.

Momentum factor shares are identified on the basis of their price-to-earnings (p:e) ratio, price-to-book ratio and price-earnings-growth ratio.

Quality factor shares are identified on the basis of measures like return on equity, leverage (debt divided by book value) and earnings variability.

Low volatility factor shares are identified by volatility measures such as standard deviation.

Small cap factor shares are identified by their market capitalisation.


Longer holding periods required

Over shorter-terms a tilt towards these factors may not always reward you as an investor. You have to be prepared to hold these investments through the economic cycle – possibly a few years - if you want returns above those of the market.

As single factor portfolios can have long periods of underperformance, some managers offer multi-factor funds that diversify across the different factors to smooth out returns.

Different providers use different strategies to combine their exposure to the different factors.