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Are smart beta funds really that smart?

The relentless march of smart beta fund launches has raised questions over whether the strategies could help active managers make gains on asset-rich passive providers.

Earlier this month, Fidelity International launched two income-focused smart beta exchange-traded funds, the first of the kind for the fund group.

As reported by Money Marketing this week, Aberdeen Asset Management and Standard Life, which are in the process of merging, are also eyeing the smart beta space, leveraging their combined £24bn quantitative strategy assets.

But as many funds come under pressure over accusations of being closet trackers, how can smart beta funds become a valid option for retail investors?

A beta solution

Broadly speaking, smart beta strategies aim to deliver better returns than conventional passive funds by using alternative weighting based on measures such as volatility or dividends.

Fifty-eight new strategic-beta ETF  products hit the European market in the year ending June, growing at a similar pace to the previous year, according to Morningstar’s latest report on the ETF market.

Assets held in these funds increased by 25 per cent to a record $40bn (£32bn) in the 12 months to June, a fourfold growth in four years.

Morningstar director of passive funds research for Europe Hortense Bioy says smart beta ETFs are growing faster than the total ETF market on both sides of the Atlantic.

Bioy argues this trend may accelerate with newer ETFs tracking “unproven benchmarks” and with more new entrants in the market.

The end of scepticism

As smart beta funds tend to be concentrated in the US and are designed for more sophisticated investors, scepticism among advisers and commentators continues.

Invesco PowerShares head of UK distribution Caroline Baron says smart beta ETFs are “a natural evolution” of investing and an “additional tool” over pure active and passive funds.

But Architas investment director Adrian Lowcock says smart beta funds are still passive funds and “there’s nothing particularly smart about them” because they lack active asset allocation.

Many of the smart beta strategies seem to be ‘over-optimised’ in that they are designed to back-test well, but it is far from clear they will perform in the future

He says: “Smart beta gives passives greater flexibility in that you can change how something is tracked but you are still investing passively. It adds more tools to the box, which is useful for those who do not want to use active at all, but that can create risks if the products are not well understood.”

AJ Bell head of fund selection Ryan Hughes says potential liquidity issues tend to keep him from picking smart beta funds over other products.

He says: “How I think about smart beta is whether they have enough liquidity to deliver what they say they will and keep the costs low.

“The same criteria push you to some of these managers but if there is a larger and more liquid fund in the same space you might just pick that one.

“It might take a smart beta fund a while to build traction compared with similar funds that already have a long track record.”

Hughes says smart beta is not very high on advisers’ agendas but argues it could be of good use tactically, for example, if targeting quality or income.

Cut the costs

While experts say smart beta is not “a silver bullet” it does help to reduce costs.

In its interim study on competition among asset managers in November, the FCA found costs of smart beta strategies are often “not significantly more expensive” than comparable passive funds.

In 2015, FTSE All-Share smart beta ETFs charged an average of 0.42 per cent while comparable market cap weighted ETFs charged an average 0.33 per cent.

Morningstar finds average costs for smart beta equity and market cap equity ETFs in Europe are 0.37 per cent, which is still more expensive than ETFs, although these costs have come down.

But despite smart beta being cheaper than most active funds, experts say pure passive funds remain the main threat to active asset management businesses.

Hughes says: “Some traditional active fund managers may try to capture more market share with smart beta ETFs but that doesn’t hit their active market share book.

“If we see more entrants it’d be interesting to see how low costs will go from here, as it happened with passive funds.”

Lowcock says a few active managers may have the scale to challenge the established tracker funds by launching more smart beta funds.

He says: “Active managers have a choice to either offer an alternative product to passives or lose the business.

“They have expertise in active management which can lend itself to building the right smart beta products which they can use to compete against the passives and scale is less of an issue in this part of the market so they can compete on equal footing with the large passive providers.”

Deep into due diligence

Advisers are urged to make sure they understand  all the different smart beta strategies, given poor information in this space, especially on performance.

Seven Investment Management head of sales Robert Poulten says due diligence should be the same as on active funds.

He says: “Advisers need to be aware that smart beta is not a panacea.

“Many of the smart beta strategies available on the market today seem to be ‘over-optimised’ in that they are designed to back-test well, but it is far from clear that they will perform in the future.”

Lowcock says concentration risk is also something to consider.

He says: “If one strategy appears to have found the magic solution of reducing risk and boosting returns significantly, then you can expect money to flow into the strategy and competitor funds to appear.

“This flow of money can skew future performance and change the behaviour and risk volatility characteristics of the funds.”

Fidelity: The rationale behind our smart beta funds

Portfolio-Bonds-Investment-Business-700x450.jpg

Smart beta products sit somewhere between standard passive products and active products and the additional cost reflects the intellectual property that goes into the design and management of these products.

Smart beta funds are designed to provide access to a particular theme or strategy in a transparent, cost-efficient way. Over any particular timeframe, they may outperform or underperform the broader market depending on the performance of the particular theme of strategy. Many smart beta products are designed to offer a better risk adjusted return over the longer term.

Fidelity International’s first two exchange-traded funds, the Fidelity US Quality Income Ucits ETF and the Fidelity Global Quality Income Ucits ETF, are designed to provide exposure to high quality stocks which pay attractive dividends.

The Fidelity Quality Income indices are designed to provide exposure to the quality income theme whilst controlling unintended risks in the portfolio.

Taking US equity income indices as an example, most of the existing indices have sector allocations that are very different the broader market, as represented by a market capitalisation weighted index, such as the S&P 500. By considering the yield of stocks relative to their sector, the Fidelity indices provide exposure to the equity income theme without an inherent sector bias.

The Fidelity US Quality Income Index applies screens to identify quality stocks based on three measures:

  • Free cashflow margin – measures how efficiently a company can convert sales to cash
  • Return on invested capital – provides a measure of profitability relative to capital invested
  • Free cashflow stability – measures a company’s ability to generate free cashflow

The index methodology then selects the highest yielding stocks within each sector. The constituents are then weighted by their market capitalisation plus an “equal active” overweight. The equal active overweight distributes an equal excess weighting to all the selected stocks within a sector so that the total sector weight is the same as the starting universe. This approach controls stock specific risk and maintains the sector exposures of the boarder market.

Nick King is head of ETFs at Fidelity International

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