Smart beta exchange-traded funds (ETFs) provide exposure to one particular market factor such as quality, value or low-volatility by weighting the components of the index being tracked differently than by market capitalisation, which is he basis of most ETFs.
The trackers are then managed automatically without ongoing human intervention but with these highly customised underlying indices.
BY providing exposure to a single market factor, smart beta ETFs act as active investments, said Poullaouec, SSGA’s head of strategy and research for the investment solutions group. In particular because they implement a view on the market.
Using smart beta products requires the investor to switch focus from selecting a manager to asset and factor allocation, he noted. “That is a really different skill set.”
Smart beta adoption
“Smart beta is a challenge to the active [approach], because if your active manager is not able to outperform smart beta, why pay active management fees?”
However, the reality is that smart beta products will likely coexist with active managers and passive funds, Poullaouec said.
While they can replace, at a lower cost, some active funds that provide pure exposure to investment factors, the do leave room for active managers who offer a truly differentiated style.
In a multi-factor portfolio, smart beta products can provide complementary exposure to factors underweighted in the active funds already held in the portfolio, Poullaouec said.
Individual investors are not the natural adopters of smart beta products. As each product reflects a view on the market, choosing them requires expertise in both asset allocation and factor allocation.
Factor investing requires looking at portfolio construction in a new way. Poullaouec describes the process using coordinates: “On the horizontal axis you can see the asset allocation and on the vertical you can see factor allocation.”
Factors, which can be interpreted as risks, often span across asset classes. For example, credit risk in the fixed income sleeve of the portfolio is aligned with equity risk in the portfolio.
As Bloomberg reported in May, there are now more indices than securities in the US. “Now you’re becoming an index picker rather than a stock picker,” Poullaouec said.
This ever growing variety allows investors to implement a range of particular investment views, just by picking an ETF.
One of the newest trends has been merging the smart beta approach with ESG. The SPDR SSGA Gender Diversity Index ETF, launched in March 2016 and listed as “SHE” on New York Stock Exchange is an example of such a product. It implements a belief that companies with more gender-balanced leadership perform better.
As new indices are created daily, providers are striving to make them “purer”. This means shedding the constraints that some indices – such as low volatility – have on how much they can depart from the original market capped index.
“That is a good start, but it is not a pure exposure to the minimum volatility factor,” said Poullaouec. “As the investors become asset and factor allocators, they need purer exposure to factors they really believe in.”
Smart beta typically focuses on one factor. A type of smart beta − the multi-factor product − is designed to provide diversified exposure to several factors.
“Different factors will react differently in the investment cycle,” said Poullaouec. “You want to have diversification to benefit from value being very weakly correlated to low volatility or quality.”
Different factors tend to perform differently during the market cycle, but timing the factors “is not the right answer for investors,” he said. The main value of the multi-factor approach is to have a broadly-diversified portfolio.
Nevertheless, overweighting certain factors at the right time can be beneficial. Notably, the value factor underperformed low volatility and quality before mid-2016, according to Poullaouec, but that changed in the second half of the year.
“That was a signal that the underlying economy and business confidence was changing,” he said.
“The value style is typically in favour in an early acceleration of the economy.” Although the trend has reversed in 2017, “we are still overweight value and underweight low volatility because we think that this is a trend that will continue to persist in .”
An old concept
Smart beta investing principles have been known for decades.
“Research in the 1970s and 80s showed that value, size and other factors can explain the alpha of managers, but only recently the industry packaged this type of research into products,” Poullaouec said.
By one definition, any index-based product that strays from market capitalisation weighting can be called smart beta.
For example, the ABF Pan Asia Bond Index Fund (an ETF), listed in Hong Kong since 2005, adjusts bond weights away from issuance size in order to focus on those with higher liquidity and to reduce the outsized allocation to Chinese bonds.
“That was a smart beta product without being called by that name. Today it would be classified as smart beta,” said Poullaouec.