Investing in smart beta ETFs

Smart Beta exchange-traded funds (ETFs) offer a way to get exposure to the investment tilts which many active managers use, to try and outperform a traditional market cap index. Almost without exception, these products offer back tested evidence showing that they can beat the market, but this is not consistent. Investors should take care to understand how they work.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Smart-beta ETFs

Smart Beta exchange-traded funds (ETFs) are designed to get concentrated exposure to factors which drive equity market returns. The best known of these are:

  • Value – buying stocks that look cheap on price to book and earnings measures
  • Growth – buying stocks that look expensive
  • Size – overweighting smaller cap stocks
  • Quality – investing in companies with robust balance sheets and steady earnings
  • Minimum volatility – buying stocks that in aggregate have smoother returns
  • Momentum – a trend following strategy that buys stocks when they go up and sells them when they fall

The launch of these investment products has seen ETF houses start to encroach on the territory of active managers, who are often tasked with managing money to a particular style. The best known example of this is the Morningstar Style Box, a grid which puts fund managers into nine different categories, from large cap value to small cap growth.

In figure 1 we illustrate this with the well-known Fundsmith Equity Fund.

Figure 1: Morningstar Style Box 

A fund selector looking for a large cap growth manager could filter funds in this manner, see that Terry Smith’s fund fitted the style box, and afterwards make an investment. Later on, if they thought the style was overvalued, they could conduct another search for a large cap value product and switch their exposure to a new manager. 

This is where Smart Beta ETFs fit in. Asset allocators can blend together different investment factors to try and deliver superior investment returns. However, rather than limiting themselves to just nine styles, quantitative analysts have found (through back testing) many different factors which perform slightly differently compared with each other under differing market environments.

iShares has, perhaps, the most developed suite of UK-listed Smart Beta ETFs, but other providers such as OSSIAM, PowerShares, Vanguard, and Russell also have an extensive range of products, and new and interesting ETFs are launched on a regular basis.

In figure 2, we can see how the factor-tilted indices have performed, versus a conventional market cap MSCI World benchmark. At the extremes sit minimum volatility, a style which has successfully differentiated itself from a market cap index, and momentum which has performed well over time but can be susceptible to sharp downturns in performance. 

Figure 2: Risk and return of MSCI Factor Indices

Different factors work well at different parts of the investment cycle. When markets are recovering, size, value and momentum should typically perform better while conversely, in an economic contraction, it tends to be growth companies (which should have a better long-term outlook) and those with quality balance sheets that outperform.

ETF providers now offer regional Smart Beta ETFs too, allowing you to go overweight selectively to different geographies as well as different styles. 

Figure 3: Factor exposures to the economic cycle

Are Smart Beta returns too good to be true?

In a paper titled “How can ‘Smart Beta’ go horribly wrong?", Research Affiliates analysed whether strong long-term performance comes from genuine alpha, or from a strategy becoming more and more expensive relative to the market. Their findings make for interesting reading.

They found evidence that Smart Beta factors can outperform in the long run, but even when you use a long return period (say 50 years), there is no guarantee that this outperformance isn’t simply driven mainly by rising valuations. For example, in the period between January 1967 and September 2015, Research Affiliates calculated that low volatility had more than half of its circa 1% excess return generated by changing valuations. Over 10 years it was even more pronounced; 1.65% of the 0.82% return was from changing valuations. In short, there was no alpha.

This illustrates that while factor exposures can make differences to your portfolio, they will not consistently outperform. In addition, chasing performances in Smart Beta ETFs that have done well can be just as injurious for your portfolio performance as buying stocks or individual markets which have recently performed well.

Smart Beta is a great tool for the investor’s armoury, but like all investments it pays to know a little about how it works before making a substantial investment.

Use our ETF screener to find the right global equity ETFs for you. ETFs can be bought on IG’s share dealing platform, where commissions start at just £5 and there are no custody or platform fees

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