Analysis: Smart Beta funds to attract further interest in the future?

Still at a relatively infancy stage, the concept is however gaining momentum across the globe. Smart Beta has been a buzz phrase in investing for some years now, but the concept is not so familiar in Mauritius. According to Aon Hewitt Ltd (Mauritius), it might gain interest in the years to come, especially since institutional investors now pay more attention to transparency and fees as well as new sources of return. According to the Financial Times, in one of its issue in December 2017, Smart Beta funds have hit the USD 1 trillion of assets milestone. What is Smart Beta all about?

Smart Beta exchange-traded funds and products attracted $69bn in net new assets in the first 11 months of 2017 according to figures from ETFGI, an industry data provider. The year-to-date growth of 30.1% was the fastest since 2009, says a Financial Times article published in December 2017. According to the article, Smart Beta funds have hit the USD 1 trillion of assets milestone, and this testifies the popularity of the investment strategy.

What is Smart Beta? Is it a popular concept? How far is it known in Mauritius?

According to Aon Hewitt (Mauritius) Dashboard for February 2018, investors often look at market capitalization before investing. As such, stocks with higher market capitalization often benefit from a higher allocation in investment portfolios.  A Smart Beta fund is however a fund which factors in anything other than market capitalization in weighing their holdings.

As such, the “beta” part of the name refers to an index, or an index fund’s return. The “smart” part means that the funds weight stocks and rely on factors other than price. These factors could for instance include low volatility, size, momentum, dividend payout, sales growth and value. Thus, with a smart beta strategy, market capitalization will not be the key consideration. Smart beta funds have been described as a modest mix of active and passive investing. Smart beta is also known as 'alternative' beta.

Explosive growth

Smart Beta attempts to improve returns, reduce risk, increase diversification and also give greater exposure to the market. By combining characteristics of both passive and active investing, investors retain many benefits of passive strategies whilst also attempting to improve returns. Smart Beta strategies implement a rule based alternative to passive investing outside of the traditional weighted capitalization strategy. They moreover attempt to increase risk adjusted returns by taking advantage of anomalies in particular asset classes.

“Smart Beta still remains in a relatively infancy stage. In the Mauritian context, it is more than likely that members of Investment Committees, Management Committees as well as Pension Fund Trustees would gradually need to get more accustomed to 'smart beta' strategies. Since institutional investors are now paying more attention to transparency and fees, they may also search for new sources of return. We therefore expect Smart Beta funds to attract further interest in the years to come”, can we further read in the document.

In general, the approach is popular with investors across the board but particularly with wealth managers and private banks. BlackRock (the world's largest asset manager), Vanguard, Aberdeen Standard Investments, Goldman Sachs, Franklin Templeton and Fidelity International have all launched Smart Beta funds. The explosive growth in Smart Beta funds also suggests investors are not as comfortable buying the market or segments of it through simple indexing. David Wickham, global head of Smart Beta at Aberdeen Standard Investments, said in an article published on the 8th of March: "Smart Beta is leading to rapid changes in the global investment landscape and is one of the fastest-growing segments of the asset management industry”.

 

Go beta but…

As with all concept, alarm bells are bound to ring. Some experts, globally, are worried about the Smart Beta approach, and have warned that returns might not be as good as some providers forecast. They are worried about the so-called back tests, which are used to assess smart beta factors, are flawed and susceptible to data mining, in which performance data are tested until the desired result is achieved or conducted only for optimistic scenarios. For them, the industry “must make every effort to avoid being duped by historical returns”.

What are the advantages and disadvantages of Smart Beta funds? Below is a list published by Aon Hewitt (Mauritius) in its February 2018 Dashboard.

Advantages of the Smart Beta approach

• Better Diversification as concentration in few stocks/ sectors is avoided

• Possibility to generate returns higher than capitalization indices over the long term

• Lower costs than a pure active strategy

• Improved Transparency

• Potential reduction in risk as stocks are weighted using different methodologies

Disadvantages of the Smart Beta approach

• More costly than a passive strategy/ traditional index funds

• No guarantee of superior performance

• No capital protection

• Could imply taking more risk and this will depend on the fund/factor selected

• Strategy/Factor might be complex to understand

 

A new type of bond fund

A Smart Beta bond fund is still an index fund, and still made up of bonds, but it is also an entirely new way to think about bond investing. Usually when someone invests in the bond market, they buy a specific type of bond, like a corporate bond. The investment is usually thought of in terms of what it is: an industrial bond, a consumer issuer etc. For example, if someone owns a Treasury bond, something he should care about is his exposure to interest rate risk because it determines how his bond performs. And if he holds a corporate bond, there are both interest rate risk and credit risk to worry about.

Now, instead of the weights of different types of bonds, investors can hone in on exposure to factors that drive portfolio performance, such as interest rate risk, credit risk, and others. It changes the conversation from “I have this much government bonds and this much corporate bonds” to “I have this much exposure to changes in interest rates, and this much exposure to credit markets”. [Source:  ETF Daily News]

 

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